What it is : Tax free bonds, as the name suggests are long term debt instruments whose interest income is exempted from the calculation of income tax. These are generally issued by government backed authorities who raise funds for various infrastructure related projected initiated by government. Some of the entities who issue such bonds are Rural Electrification Corporation (REC), the Power Finance Corporation (PFC), National Highway Authorities of India (NHAI), HUDCO, NTPC, National Renewable Development Agency etc.
Structure of the tax free bonds : The Tax Free Bonds are issued for fixed tenures such as 10 Years, 15 Years and 20 years. They used to pay a fixed coupon rate or rate of interest over a fixed tenure. The coupon rate is paid out on regular intervals, usually, semiannually and the principal amount is returned on maturity. The bonds can be traded in the secondary market and are secured and redeemable and non convertible in nature. Retail Investors, Qualified Institutional Buyers (QIBs), High Net Worth Individuals (HNIs) can subscribe to the bond issue.
Generally bonds are listed within 15 days of closing of the issue. Generally, the allotment is done on first come first serve basis. Anyone who is interested in investing in the bonds can hold the bonds in demat as well as physical form.
The coupon rate : The coupon rate that a Tax Free bond can offer depends on two factors. The first factor is the rate of interest that a government security (G-Sec) can earn at the time of issue. The coupon rate of the tax free bond can be a few points lower than the G-Sec of the same tenure. For example, if an issuer comes up with an AAA rated bond for a period of 15 years, the interest earned by a retail investor will be 0.5 percent lower than a G-Sec and 0.8 percent lower for all other class of investor. The other factor which influence the coupon rate is the rating of the issuing agency. Similarly a bond issued by a AA+ rated issuer will earn a little more than an AAA- rated issuer. Lower the rating of the issuing agency, lower will be the coupon rate.
The tax angle : The interest income earned through these bonds are exempted from calculation of income tax under section 10 (15) ( IV) (h) of Income Tax Act 1961. However there are conditions under which the capital gains from such bonds will not be eligible for taxes exemptions are
1. Capital gains on selling or transferring of the bonds in the secondary market. The tax rate will be applicable according to the income slab of the investor
2. Capital gains through sale or transfer of the bonds within a period of 12 months from the issue of the bonds will be taxed. Capital gains beyond a period of 12 months will be taxed 10.3 percent
3. There will not be any tax benefit on the principal amount and is applicable to TDS deductions
Who gets the most tax benefit : The benefit of investing in the tax free bond is measured thorough effective rate of interest (effective yield) which can be calculated through formulae as below
Effective yield = coupon rate / (1-tax rate)
Tulika Devi Nath