Indian investors are spoiled these days with the range of choices when it comes to investing.
From investment schemes offering monthly, quarterly, half-yearly as well as annual returns, to schemes offering taxable as well as non-taxable returns, the list is endless. Choosing the right investment avenue, therefore, may not be as easy as it appears. But a successful investor is not the one who invests in the stocks producing maximum returns quickly but the one which is sustainable and also which prevents you from paying taxes on your returns. One of the hugely-popular investment options, especially among high net worth investors, is tax-free bonds.
Let's see what these bonds are and how they work.
Understanding Tax-free Bonds:
Tax-free bonds have acquired a lot of popularity these days considering that the interest income earned from these bonds are free from being taxed. These bonds are issued by government enterprises and there is hardly any risk of non-payment of interest amount.
Apart from the zero risk, the biggest advantage of tax-free bonds is that they provide tax-free income. The interest you earn from tax-free bonds is exempt from tax under section 10 of the Income Tax Act, 1961.
When you invest in an ordinary bond or a bank FD, the interest income is added to your income tax slab and tax is levied accordingly. So, if you fall in the highest tax bracket, your interest income is taxed at 30%. But in the case of tax-free bonds, even if you fall in the 30% tax bracket, your tax payable is Nil. Hence, tax-free bonds are extremely popular among high networth individuals (HNIs).
For example, few of the National Highways Authority of India (NHAI) bonds are tax-free in nature and the proceeds are used for infrastructural development of highways in India. Since tax-free bonds are issued by the government, they are extremely safe and carry zero default risk.
Before we dive deep in how the tax free bonds work, let's first understand the credit rating.
Tax Free Bonds and Credit Rating:
As it is well established that tax-free bonds experience very little to zero default risk, still it is always recommended to study the details of every company (as discussed in our previous post) and check their credit rating before investing. Bonds are rated by credit rating agencies like CARE, CRISIL, ICRA on a scale of AAA to D.
- Low credit rating implies higher risk and higher interest rate.
- High credit rating implies low risk and lower interest rate.
Credit Ratings Scale
- AAA - Low credit risk and highest degree of safety
- AA - Low credit risk and a high degree of safety
- A - Low credit risk and adequate degree of safety
- BBB - Moderate credit risk and a moderate degree of safety
- BB - Moderate risk of default
- B - High risk of default
- C - Very high risk of default
- D - The security has already defaulted or is expected to be in default soon
The credit rating of any Issuer/security is never constant. Credit rating companies may change the rating whenever the agencies think that the financial health / probability of default for the issuer has changed.
The credit rating agencies also use modifiers such as + (plus) or – (minus). The rating of AA+ is one notch higher than AA, while AA- is one notch lower than AA.
Credit ratings work on the principle that the highest rated company is most likely to pay interest on the principal and to return the principal on the scheduled dates irrespective of whether the company makes profits or incurred losses.
Highly Rated Indian Tax Free Bonds Issuer in 2022
Company Credit Ratings
PFC- Power Finance Corporation CRISIL AAA
NHAI- National Highways Authority of India CRISIL AAA
IRFC-Indian Railway Finance Corporation CRISIL AAA
REC-Rural Electrification Corporation Limited CRISIL AAA
Tax-Free Bonds Jargons:
Face Value: Face Value is a static value assigned by the company which brings the bond to the market. It is also known as Par-value and used to be printed on the bond certificate.
Coupon Rate: The Coupon rate is the rate of interest paid by issuers on the bond's face value. It is the regular rate of interest paid by the issuer to the bond holder.
Price of the bond: When the bonds are bought and sold in the secondary market, the price at which they are sold in the secondary market is known as the price of bond. It can be above or below the face value, depending upon the financial health of the issue and current economic environment (to know more about Intraday Trading Jargons check our previous blog.)
Advantages of Tax-Free Bonds:
1. Tax-Exempt Interest Income: As the name suggests, the interest earned from tax-free bonds is exempted from tax. Additionally, even the tax deducted at TDS is not applicable in case of tax-free bonds.
2. Superior Post-Tax Returns: Fixed deposits have been a conservative investor’s best friend. But in recent years, they have lost their charm as interest rates on bank fixed deposits have decreased considerably.
3. Long-Term Tenure: Tax-free bonds are suitable for investors with a long investment horizon as their tenure ranges from 10 to 20 years or more.
For example: Power Finance Corporation Tax-Free bond was first issued on 15th October 2011. The tenure of the bond is 15 years and it will mature on 15th October 2026. So, if you are a long-term investor, then tax-free bonds generate superior tax-adjusted returns compared to bank FDs and ordinary bonds.
4. Zero Default Risk: Tax-free bonds are issued by public sector undertakings. Hence tax-free bonds are extremely safe and carry zero default risk unlike other bonds. So, investors get the comfort of staying invested for the long-term as their principal and interest repayment is assured.
Tax Implications on Tax-Free Bonds:
- The interest you receive from tax free bonds is tax-free.
- Short-term capital gain is calculated at the slab rate depending on an individual’s income. Whereas, long-term capital gain is taxed at 10% without indexation or 20% with indexation, plus surcharge.
- If you sell the bond in less than 12 months, then the capital gains are taxed as per your income tax slab.
Thus, the tax-free bonds are ideal for modest risk appetite investors as well as high net-worth individuals who are looking for a steady source of annual income, and for those who can afford to lock-in their capital for longer tenures. It is very important to understand that the above discussed Tax Free Bonds are different from the Capital Bonds which fall under Section 54EC, (to understand more about Capital Tax Bond, check out our blog). If you already have an account with ShareIndia, login to your account, and if you are a beginner sign up here.
Disclaimer: Any advice or information in the post is a general advice for education purpose only and is not responsible for generating any trading strategy for anyone, please do not trade or invest based solely on this information.