Tax-Free Bonds Worth Rs 40,000 Crore Coming Soon: 10 Facts

The government has allowed seven state-owned entities, including National Highways Authority of India (NHAI), Indian Railway Finance Corporation (IRFC) and National Thermal Power Corporation Ltd (NTPC), to raise Rs. 40,000 crore in the current fiscal through tax-free bonds.

Tax-free bonds are usually issued by government-backed entities to raise long-term funding for infrastructure projects.

Here is a 10-Point Cheat-Sheet

1) The interest earned on these tax-free bonds does not attract tax but investments made in tax-free bonds are not eligible for income tax deductions. Also, there is no deduction of tax at source (TDS) from the interest earned on tax-free bonds.

2) Tax-free bonds have low default risk because they are issued by government-backed entities. Credit agencies rate these instruments after assessing the financial health of the entities issuing the bonds.

3) The tenure of these tax-free bonds will be for 10, 15 or 20 years. The interest on these bonds is paid twice a year or annually. The minimum denomination of these bonds can vary from Rs 1,000 to Rs 5,000.

4) Financial planners say that for investors in the higher tax bracket, tax-free bonds are an attractive option at a time when bank fixed deposit rates are coming down.

5) The interest rate offered by these new issues will be based on the yield on government security of equivalent maturity. At prevailing interest rates, a retail investor can expect to earn nearly 7.25-7.75 per cent annually by subscribing to these bonds, say experts.

6) This means a subscriber in the 30 per cent tax bracket can earn 10.85 per cent annually in effective return over the tenure of a 7.5 per cent bond as the interest is not taxable. For subscribers in the 20 per cent tax bracket, the effective return is 9.45 per cent and for 10 per cent, the slab is at 8.35 per cent. In comparison, interest income on fixed deposits is taxed according to the individual's tax slab. (The prevailing interest rate on a 5-10 year fixed deposit in SBI is around 8 per cent.)

7) Retail investors can invest up to Rs 10 lakh in each issue. Individual investors putting in more than Rs 10 lakh are classified as high net-worth individuals. About 40 per cent of a public issue is earmarked for retail investors.

8) However, as compared to a bank fixed deposit, the tax-free bonds are less liquid even though these bonds are listed on stock exchanges. Investors can exit from these tax-free bonds before maturity by selling them on stock exchanges. But in some cases, they may be thinly traded.

9) Capital gains made on selling of tax-free bonds on stock exchanges are taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges are taxed as per the tax slab of the investor. If bonds are held for more than 12 months, the gains are taxed at 10 per cent.

10) What experts say: Vishal Dhawan, director of Plan Ahead Wealth Advisors, says tax-free bonds remain an attractive option for individuals in the higher tax bracket and eliminates the reinvestment risk in an environment where interest rates are expected to trend lower. Reinvestment risks imply the probability of interest rates going lower in the future.

Anil Rego, CEO of Right Horizons, a wealth management firm, says tax-free bonds are a good option investors in higher tax brackets but they should keep the liquidity factor in mind before putting their money.