Bonds are one of the many investment strategies used to manage personal finance. Bonds are debts given to entities for a fixed amount of time at a fixed interest rate. There is a special category of bonds which attracts eyeballs every time they are announced because of the benefits attached to them. These are tax free bonds. As the name suggests, these bonds enjoy tax exemption on the interest income earned from them. They generally pay lower coupon rate than corporate bonds, however the tax exemption feature puts them at a better bet than corporate bonds.
The following features must be kept in mind before opting for these bonds:
- The after tax interest income is higher than those offered by corporate bonds.
- There is no benefit of compounding or reinvesting as in fixed deposits.
- They are listed on stock exchanges which makes them liquid as can be sold in a secondary market.
- Have higher maturity periods than most other investment options. The investment horizon is from 10-15 years.
- Bonds are listed in the market, due to which they give the benefits of capital gains when interest rates go down.
- Holding of bonds in demat form makes it easier to handle them.
- Retail investors are sometimes given a 0.50% higher interest rate if they are new investors in the scheme.
- Enjoy high credit rating as are generally offered by government entities.
- There is neither any tax exemption at the time of investment nor at the time of sale in a secondary market. There is a tax exemption only on the interest income earned from such bonds.
- Effective yield is generally used to depict these bonds.
Effective yield = Coupon rate/(1-tax rate)
However, this may not be a fair indicator of a bond because it differs with different tax rates.
- Generally those investors who are looking for long term investments should invest in these bonds and not those who are looking at capital gains.
- Investment in tax free bonds can be made at the time of their public issue by filling up the required form or at a later stage when they are listed on a stock exchange
Some of the latest tax free bonds issued in India are:
- India Infrastructure Finance Company
- Railway Finance Corporation
- National Highways Authority Of India
- National Housing Bank
- Power Finance Corporation
- Rural Electrical Corporation
- Jawaharlal Nehru Port Trust
- Ennore Port
- Dredging Corporation of India
The coupon rates of these bonds lie in the range of 7-8% with a long term investment period ranging from 10-15 years. Most of these bonds are issued under multiple tranches and multiple series, each offering different coupon rates. The issue of these bonds was closed in March, 2013. Most of the bonds trade on Bombay stock exchange and their current prices can be viewed at http://www.moneycontrol.com/fixed-income/bonds/listed-bonds/.
Government of India has granted permission to a few other corporations to issue their tax free bonds as well. Some of them are:
- NTPC is set to raise Rs. 2,500Cr from tax free bonds this fiscal to support its capital expenditure. NTPC has requested the government for a maturity period of 10-20 years. These bonds will also be issued in tranches.
- The importance of the issuance of tax free bonds by Municipal corporations has also been raised due to Detroit’s debacle and the degrading financial health of Indian municipalities.
- NHPC is also planning to raise Rs. 1000Cr via tax free bonds but is awaiting Finance Ministry’s nod.
- AAI is set to launch tax free bonds to raise Rs. 1000Cr to develop airports across the country.
The benefits of tax free bonds must be weighed against the benefits of other attractive and similar investment avenues like fixed deposits before investing in them. The following points must be always compared before opting for an investment option:
Analyse your own liquidity needs and match it with the liquidity provided by various investment avenues. For E.g.: Liquidity of investing in equity is the highest as compared with tax free bonds and fixed deposits. Tax free bonds will be generally considered as being more liquid than fixed deposits because taking out money from an FD before the maturity period generally lowers the interest rate offered by the bank. An exception to this is IDBI, which does not lower the interest rate being offered on its FD on withdrawal of money.
- After tax interest rate/coupon rate
Compare the after tax interest rate being offered by an FD, dividends offered by an equity investment and the coupon rate of a tax free bond.
- Maturity period
The maturity period of an equity investment is the shortest, followed by that of a fixed deposit and then a tax free bond.
- Capital gains
Capital gains are the highest in equity as compared to fixed deposits and tax free bonds.