Buying Tax-Free Bonds in the Secondary Market in India
Last Year i.e. 2016 saw an influx of Tax-Free Bonds from many Government PSU ( Public Sector Undertakings) but this year there is not a single offer in the market and neither government plans to bring any (Thanks to tons of liquidity with Banks due to demonetization). But Tax-free bonds can still be purchased on the secondary market (via a Demat account) on both NSE and BSE stock exchanges.
How would you decide? What parameters?
But how would you decide if you should buy these tax-free bonds in the secondary market? Should we just look at the coupon rate and choose the one which is higher?
The answer to these question – Frankly, it depends on the purpose of the purchase. If you buying to get a regular income with safety of principal in mind then higher coupon rate may be the only thing that matters. Most of the tax-free bonds are trading at a premium on these stock exchanges.
Given that these are trading at a premium, then one question that comes to mind is that should you invest your hard earned money in these bonds or be satisfied with returns of Bank Fixed Deposits? Well if you fall under 30% tax bracket then these bonds are a very good option even when bought at a premium. See this example below to make it clear –
Premium and YTM:
Please understand the YTM (Yield to maturity) on these before you go ahead with the purchase. Yield to maturity is the internal rate of return (IRR) of the bond purchase, assuming all payouts are reinvested at the same IRR. This is practically not possible in real life but for calculation purpose, let’s assume that these are reinvested at the same IRR. There are many YTM calculators available online and even Excel has a function for it. The one from Investopedia (Opens in a new window) can be used to calculate the YTM. Even NSE gives you the YTM based on the last traded price which can help you decide about your purchase. Link to NSE
Also, don’t confuse these Tax-Free Bonds with Tax Saving Bonds
Major Differences between Tax Saving Bonds and Tax-Free Bonds:
- Bonds which do not attract tax on interest earned are termed tax-free bonds
- Not eligible for deduction under Sec 80C of the Income Tax Act
- Interest is not taxed by the government
- Deduction permitted in IT return – Nil
Tax Saving Bond
- Tax Saving Bonds attract taxes but the investment is eligible for tax deductions
- Provision for deduction under Section 80CCF is provided. And this deduction is excluding the Rs 1.5 lakh provided under Section 80C of the Act.
- Interest earned is taxable by the government
- Deduction permitted in IT return – Maximum of Rs 20,000 per year
Do you want to know of more Tax-Free Income Ideas in India? Click here to know about Top 10 Tax-Free Income Ideas in India.
Other Points to Keep in mind before Buying Tax-Free Bonds
Carefully selected bonds will work as a safe refuge for your investment funds.
In this instance, tax-free bonds may work out to be the best investment decision because they are absolutely free from income tax payment. Nevertheless, before investing in tax-free bonds you must know the fundamental facts regarding tax-free bonds and also how they operate :
- Tax-free bonds have a lock in-period of ten to twenty years. The sum invested in a tax-free bond simply cannot be withdrawn before the expiry of specified lock-in time period.
- Even though the interest earned by making an investment tax free bonds is not taxable, any capital gains received from selling off these tax free bonds in the secondary market are taxable.
- Tax-free bonds are made available both in demat format and physical mode.
- The interest earnings gained from these bonds are totally free from income tax.
- These bonds carry Credit Risk i.e. the risk of non-payment. Though this risk is very low in tax-free bonds mainly because they are issued by the Government PSU with AA or AAA credit rating
- Rates of interest on tax-free bonds range between 7.3% to 7.5% per year. But, these interest rates are dependent upon the credit ratings on bonds given by credit rating agencies.
- Liquidity Risk – Investors need to be aware that some bonds are not very liquid, which means that when you want to sell and you put in a sell order, there might not be many buyers and you may not get a fair price. Currently, I have seen decent demand for most of these bonds so the liquid risk is very low but that situation could change in future. Moreover, expectations of interest rate also plays a role in supply and demand of these bonds which affect liquidity of these in the secondary market. It is important to note here that since these bonds are of long duration, one can avail loan against them from any bank.
- You can buy bonds in the secondary market online through a broker like ICICI Direct or Zerodha, which will deposit the bond in your demat account.
Role of Tax-Free Bonds in Financial Planning
Given the fact that these Bonds do not attract tax on interest earned, they are very popular with High Networth Individuals primarily due to the fact that it allows them to invest a huge lump sum at one place. Further, they are perceived to be relatively safe as they are primarily issued by government institutions and carry high investment grade ratings. Also, the effective pre-tax yield is high for those in the top income slab.
So if you are doing your own financial planning, consider these bonds after evaluating these 3 points:
- You don’t mind blocking your money for ten to twenty years. As I said above, the sum invested in a tax-free bond simply cannot be withdrawn before the expiry of specified lock-in time period.
- You need regular income (read annually).
- You are in income-tax slab