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People seek investment options that provide them with good financial returns. Zero tax on the returns, among other benefits makes tax-free bonds one of the most sought-after investments in the market. Hence, in this article, we will cover the following aspects of these low-risk bonds.

1. What are Tax-Free Bonds?

Tax-free bonds are types of goods or financial products, which the government enterprises issue. One example of these bonds is the municipal bonds. They offer a fixed interest rate and hence is a low-risk investment avenue. As the name suggests, its most attractive feature is its absolute tax exemption as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of ten years or more. Government invests the money collected from these bonds in infrastructure and housing.

2. Who should invest in Tax-Free Bonds?

Tax-free bonds can be the right choice for investors looking to earn a fixed annual income from the interest proceeds. Since these bonds have a long-term maturity period, tax bonds suit people with a low-risk profile, and those can afford a long-term lock-in period.

Qualified Institutional Investors defined by SEBI under the Disclosure and Investor Protection Guidelines can invest in these bonds. Partnership companies & limited liability groups are also eligible. Entities like trusts, co-operative & regional banks and corporate companies have been regular investors in tax-free bonds over the last few years. Individuals, including HUF members and NRIs as well as high net-worth individuals, often choose this to diversify their portfolio can also opt for these bonds.

3. What are the features of Tax-Free Bonds?

a. Tax-exemption

In the case of tax-free bonds, the income you earn in the form of interest is entirely free from income tax. There is no tax deducted at source (TDS) applicable to these bonds either. However, it is advised to declare your interest as income as tax-free bonds do not imply that you can claim the investment amount for the tax deduction. Tax-free bonds, when compared to the bank FDs, offer great benefits to investors who fall in the high tax bracket.

b. Risk factors

Chances of defaulting on interest payment are very low as these schemes are from the government itself. It also offers capital protection and a fixed annual income. Hence, it is quite safe.

c. Liquidity

You cannot liquidate tax-free bonds as quickly as, say, debt funds. Since government bonds are long-term investments and have more extended lock-in periods, liquidation of the bonds may not be that easy. Hence, tax-free bonds do not act as an emergency fund.

d. Lock-in tenure

Tax-free bonds have higher lock-in-period that range from 10 to 20 years. You cannot withdraw your money before the maturity date. Therefore, please make sure that you will not need this money shortly before investing.

e. Issuance & transaction

Tax-free bonds are issued through a Demat account or in physical mode. They mainly trade in stock markets. Hence, the interest you earn on these bonds is tax-free. However, the capital gain from selling these bonds in stock markets is taxable.

f. Returns

The returns you make on these bonds are primarily dependent on the purchase price. This is because they are traded in low volumes with a limited number of interested buyers or sellers.

g. Interest

The rate of interest offered on tax-free bonds generally ranges from 5.50% – 6.50%, which is fairly attractive when considering the tax exemption on these bonds. The bondholder receives the interest annually. However, the rates are subject to fluctuations as they are related to the current rate of government securities.

4. What are the commonly found Tax-Free Bonds?

Many public undertakings issue tax-free bonds. National Highway Authority of India, NTPC Limited and Indian Railways, Rural Electrification Corporation are some of the widely known ones. Housing and Urban Development Corporation, Indian Renewable Energy Development Agency, Rural Electrification Limited and Power Finance Corporation are other examples. Therefore, you must always check the authenticity before buying.

5. How are Tax-Free Bonds different from Tax-Saving Bonds?

Tax-free Bonds

Tax-saving Bonds

Interest (income) you earn is tax-exempt

Just the initial investment is tax-exempt

Section 10 of the Income-tax Act

Section 80CCF of the Income Tax Act

Offer higher interest rates than tax-saving bonds

Lesser interest rates compared to tax-free bonds

Can invest up to Rs. 5 lakhs

Tax-exemption is only up to Rs. 20,000 investment

Higher lock-in period from 10 years

Has a buyback clause – you can withdraw investments after 5 or 7 years

6. How to invest in Tax-Free Bonds?

Tax-free bonds have trading options that allow bond trading through a Demat account or in physical form. Therefore, availing investment opportunities in these bonds are simple and highly rewarding. Remember, the subscription period for the investment is open only for a specific time. You will be required to submit your PAN details when buying the physical format.

When the government releases them to the public, the investor can conduct the trading by applying online or offline. On the other hand, if the investor requests for the bond post-issuance, he/she can invest using the trading account. Hence, it is much similar to trading shares in stock markets.

7. How to redeem your Tax-Free Bonds?

Redeeming the tax-free bond is an easy process once you have completed the tenure. However, you cannot withdraw your bond before 10-20 years, but only trade it on stock exchanges to another investor. The entity that issued the bond in the first place cannot repurchase it either. Moreover, the profit you make after the sale is also taxable under Section 112. Hence, the gains you get after selling the bond before one year is taxable as per your income tax slab. Trading it after one year without indexation will attract 10% LTCG on gains. With indexation, the tax will be 20% post one year.

Conclusively, the options to invest in tax-free bonds offer fixed tax-free income at low risk. They are easily liquid via trading of these bonds in secondary markets before the maturity period. However, the government hasn’t notified on the issuance of these bonds since 2016. So, investors need to be aware of tenure and interest rate if they are considering those by PSU companies.

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