What are tax-free bonds? Why are they better than Fixed Deposits? Everything you should know

If you want a number of benefits while making an investment, then tax-free bonds are the best option for you.

Every one wants to make best gains on their hard-earned money. We all look for something which guarantees return, has low risk and commendable gains. One would think fixed deposits are best and safest medium, but if you look closely, the gains in FDs are not that attractive compared to a host of other investment options. Even gains earned on FDs are taxable, hence, you don’t get exactly what is promised. What would be better then having an investment which is tax free, low risk, guaranteed return, market related gains and secure? If you want these benefits while making an investment, then tax-free bonds are the best option for you.

Tax free bonds stand out because it is an investment made in various types of goods or financial products which are issued by government - this is case of security.

They are offered at fixed interest rate, hence, proclaiming low risk avenue. Just like the name suggests, this investment’s most attractive feature would be absolute tax exemption, as per section 10 of Income Tax Act. This would be like icing on the cake over your investment.

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Generally, tax free bonds are best when invested for long-term period having maturity of typically ten years or more. The government takes your money which are collected from these bonds in infrastructure and housing projects.

Who are eligible to invest in tax free bonds?

Retail Individual Investors (RIIs) who includes members of Hindu undivided family (HUF) and Non-Resident Indians (NRIs).
High Net-worth Individuals (HNIs) are the ones who usually have a low-risk appetite and can invest up to Rs 10 lakhs.
Qualified Institutional Buyers (QIBs) - who are defined under market regulator Sebi’s act.
Finally, corporate, trusts, co-operative banks and regional rural banks can also invest in tax free bonds.

Features of tax free bonds:

1. The most common feature of these bonds are tax exemption, as the income you earn in form of interests is entirely free. This means there is no tax deducted at source (TDS). Such also means that you are not allowed to claim any tax deduction on your investment amount. Therefore, one needs to declare the interest as income. Tax free bonds are better than FDs as it offer far more benefits to investors especially who are in high tax bracket.

2. Interest rates on these bonds are fairly attractive, and are earned on annual basis. There can be fluctuations in current interest rate as they are linked to government securities performing on markets.

3. Risk under this scheme is quite low, as the chances of defaulting is minimum considering these schemes are offered by government itself. Not only this, the scheme also offers capital protection and annual income.

4. It needs to be noted that, tax-free bonds cannot be liquidated as easily as debt funds because the government bonds are long-term investment and come with a lock-in period. Hence, one cannot treat it as an emergency fund.

5. They have higher lock-in period ranging from 10 to 20 years or depending upon your choice but minimum 10 years is there. Hence, it is advisable if you do not plan to depend on tax free bonds gains as your emergency source but a longer-term like retirement plan, then it is good investment for you. But you feel that you would be in need of funds in near future, then it is not advisable. Hence, always make a back-up plan before availing the benefit of tax-free bonds.

6. Issuance of tax-free bonds are carried through both demat account or physical mode and trade in stock markets. Hence, the interest you earn is tax free, but the gains from selling these bonds are taxable.

7. Returns that you make on these bonds are majorly dependent on your buying price, because they are traded in low volumes having limited number of interest buyers and sellers.

How to redeem tax-free bonds?

According to ClearTax report, redeeming the tax-free bond is not difficult if you have completed the tenure. However, you cannot withdraw your bond before 10-20 years, only trade it on stock exchanges to another investor. The entity that issued the bond in the first place cannot buy it back either. And the profit you make after the sale is taxable under Section 112.

Hence, ClearTax adds that, 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.

According to GoodReturns report, there are six tax free bonds which look good for tax free income. They are:

Indian Railways Finance Corporation N1 Series - The bonds, which were issued at Rs 1,000 are currently trading at Rs 1134. It offers interest rate of 8%. The yields are the best only for those in the highest tax bracket.

HUDCO N2 Bonds - The HUDCO N2 Bonds are good for those in the highest tax bracket. The bonds are offered at an interest rate of 8.2 per cent and the interest is paid every year on March 5. The coupon rates are much better than the Indian Railways one, though the yields have dropped due to a gain in prices. At the moment, the HUDCO Bonds are trading at Rs 1,183.

HUDCO N3 Bonds - This bonds are almost similar, though they give a coupon rate of 8.1 per cent only. The bonds are currently priced at Rs 1,110 and the next interest payment date is March 5, 2018.

National Highways Authority Of India - It offers a coupon rate of 8.2 per cent and like all of the companies, they are government owned and hence very secure. The bonds are priced at Rs 1,165 on the NSE.

REC N6 Bonds - It offers a coupon or interest rate in excess of 8 per cent. Actually, the interest rate is 8.46 per cent. This is excellent by any stretch of imagination, especially since the interest earned is tax free. One of the better bonds in terms of interest and coupon rates, though the price is a little high at Rs 1,200.

Indian Railways N7 Series - It offers an interest rate of 8.23 per cent. Again, a better coupon rate as compared to most tax free bonds. The bonds are currently priced at Rs 1,136 on the National Stock Exchange. The next interest payment of these bonds is only in April of 2018.

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