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Tax-Free Bonds: Features, Benefits and How to Invest

Tax-free Bonds

With the end number of investment options, Tax-free Bonds are the only Bonds that never lose their popularity among investors and always remain in the limelight due to their special feature of providing tax-free interest payments. The zero-tax benefit, apart from regular and secured cashflows, attracts investors. (These are different from bonds and help in tax savings. The tax savings bonds provide exemption received under Section 80CCF of the Income Tax Act, 1961.) 

Features of Tax-Free Bonds 

  1. Interest Rate – The interest rate provided on tax-free Bonds remains constant, unaffected by market fluctuations which makes them a safe and secure investment option. The yield rate is generally between 5.5-7.5% (coupon rate being in the (7-9% range), which is considerably lower than other bonds since the bonds usually trade at a premium due to their popularity for zero-tax benefit. 
  1. Lock-in Period – Tax-free bonds are long-tenure bonds with 10-20 years of maturity, and early redemptions are impossible. However, tax-free bonds are traded in primary and secondary markets both. They are listed on the exchanges and can be sold before maturity. 
  1. Issuance &Transaction – Tax-free bonds can be issued either in electronic form through a Demat account or in physical form. Purchasing tax-exempt bonds from the secondary market can be a strategy to accomplish short-term financial objectives. 
  1. Tradable – Tax-free Bonds can be traded in the secondary market, which means that the investors have the option to sell out their Bonds in the secondary market to other investors before the maturity time.  
  1. Credit Rating – Tax-free bonds are typically assigned with AAA credit rating by independent credit rating agencies like CRISIL, ICRA, And CARE. The ratings indicate the creditworthiness of the issuer and provide investors with an assessment of the risk associated with investing in the bonds. 
  1. Minimal Risk – The chances of default on both principal and interest payments is extremely low in these schemes since they are issued on behalf of the government. Additionally, tax-free bonds provide capital protection and a steady monthly or annual income, making them a considerably safe investment option. 

Benefits of Tax Saving Bonds 

Here are some of the benefits of Tax saving Bonds: – 

  1. Capital Preservation – Tax-free Bonds generally come with the assurance of capital preservation. The principal amount invested is secure, reducing the risk of losing the initial investment.  
  1. Long-term Investment – Tax-saving Bonds often have a longer lock-in period, which encourages investors to adopt a long-term investment approach. This can be beneficial for individuals looking for stable returns over an extended period.  
  1. Fixed Income – Tax saving Bonds offer a fixed interest rate throughout the Bond’s tenure. This ensures investors a predictable and stable income stream along with financial security. 
  1. Liquidity – Tax-saving Bonds come with a lock-in period, but they can be traded in the secondary market after the lock-in period expires. This provides investors with a degree of liquidity and the option to exit the investment if required.  
  1. Diversification –Tax-saving Bonds can be an excellent choice for investors if they are looking for investment diversification. By spreading investment across different asset classes, investors can reduce the impact of market fluctuations on their portfolios. 

How to invest in Tax-free Bonds? 

To invest in tax-free bonds, you can follow these steps: 

  • Research and Select: You can start by researching different types of tax-free bonds available in the market. But keep these necessary factors in mind, like the issuer, interest rates, credit ratings, and maturity periods, that will help you make well-versed investment decisions. 
  • Open a Demat Account: Open a Demat account with a registered depository participant. This account will allow you to hold your tax-free bonds in electronic form. 
  • Complete KYC Formalities: Ensure that you have completed the Know Your Customer (KYC) process, which typically involves submitting identity proof, address proof, and other required documents to comply with regulatory guidelines. 
  • Choose the Mode of Investment: Decide whether you prefer investing in tax-free bonds through the primary or secondary markets. In the primary market, you can opt for new issuances directly from the issuer during the issuance period. In the secondary market, you can buy tax-free bonds from other investors who are willing to sell. 
  • Place Your Order: If investing in the primary market, submit your application and make the required payment during the subscription period. If investing in the secondary market, place a buy order through your trading account specifying the quantity and price at which you wish to purchase the tax-free bonds. 
  • Monitor and Hold: Once you have invested in tax-free bonds, monitor their performance periodically. Hold the bonds until maturity to receive the full benefit of tax exemption and interest payments. 

Who should invest in Tax-free Bonds? 

Tax-free Bonds are the best choice for investors seeking a fixed income source, especially Senior Citizens. The Government of India issues these Bonds for longer time periods; due to this, the risk factor is comparatively very low, and the investor is assured of a fixed income for many years. 

The funds raised from the issuance of these bonds by government enterprises are utilized for infrastructure and housing projects. Tax-free bonds are particularly suitable for investors who fall within the highest tax bracket. 

Typically, high net-worth individuals (HNIs), members of Hindu Undivided Families (HUFs), trusts, cooperative banks, and qualified institutional investors show a preference for investing in tax-free bonds. 

Current scenario of tax-free bonds 

There have been no new issues of tax-free bonds in recent years. The last issue was by Indian Renewable Energy Development Agency Limited in January 2016 with 20 years of maturity. Since there has been no news or updates of further issues, there is less likelihood of the government showing intentions to go down this route. So currently, only the bonds yet to mature are available via NSE and BSE exchanges for investors seeking to park funds in the tax-free bonds.  

There have been 301 issues of tax-free bonds between 2011 to 2016, with 222 issues yet to be redeemed. Out of these 222 issues, 41 issues still have a 10-13 years maturity period. The investors can choose to park their funds depending on the time horizon they deem favourable. 

Years to Maturity Average Yield Number of Bonds maturing Value Outstanding (Rs. in Crores) 
0-3 years 5.17% 83 23373.668 
3-6 years 5.16% 69 41443.733 
5-10 years 5.18% 29 31423.461 
10-13 years (up to 2036) 5.19% 41 10080.826 
Total  222 106321.688 
(Source: NSDL, BondsIndia Research)

List of outstanding Tax-free Bonds as of May-2023 

With 90% of the remaining tax-free bonds being redeemed in the coming decade, it will be interesting to see what options investors will avail in future. Will they opt for AAA bonds or choose NCDs with lower ratings but higher yields to fill the tax void? With HNIs, Corporates, and trusts being the key demographic of these bonds, would we see a swing to more risk-tolerant products like low-rated papers/Corporate Fixed Deposits, or would they prefer to play it safe with G-secs/AAA bonds? 

Still, investors looking to invest in tax-free bonds can consider allocating their funds to the (0-13) year maturity bracket. This particular time frame offers a lucrative opportunity for saving money over the next decade unless there are subsequent issuances of bonds. By investing in this bracket, investors can take advantage of tax-free bonds’ attractive terms and benefits, maximizing their potential returns and ensuring tax-efficient savings for the coming years. 

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