Tax free bonds are those bonds issued for long term, for investment horizon of 10 to 15 years, in which interest earned is exempt from tax.  Tax free bonds do not provide any benefit of tax savings but only interest earned on these bonds is tax exempt. Since there is no tax on interest earned, these bonds are touted as much more attractive than bank fixed deposits.Like the shop keeper puts a sale note UPTO 40% off, one has to realize that 40% is only on selected items which will be very few . One has to look beyond Tax free  part.  In this article we shall explain about tax-free bonds covering features of tax free bonds,Taxation and Effective Yield,Comparison with other investment options like PPF, Fixed Deposits,Different from Tax Saving Bonds.

Tax Free bonds

Bonds form the part of  Debt as an asset class. This implies that the investor has given a loan to the issuing entity, and will be repaid at the end of the tenure as specified. Let”s understand what are Tax Free Bonds.

• Tax-free bonds are rated long-tenure (usually 10-15 years) fixed-income securities offering annual interest.
• These bonds are generally issued by government backed entities, so low risk of default, since companies have a better credit rating.
• The interest rate, also called as coupon rate, would be less than the yield of government securities of similar tenure. In Dec 2012, 10-year government bonds are trading around 8.2%. The interest rate offered by these bonds for FY 2012-13  is 7.5-8%.
• The interest on these bonds will be paid annually on a fixed date.  There is NO cumulative option.
• Interest earned would be tax free, hence the name Tax Free bonds. Tax free status of interest income is as per Section 10(15)(iv)(h) of the Income Tax Act, 1961.
• There is no tax saving on the amount invested in these bonds. Section 80C,80CCF, 80D,54EC etc are not applicable.
• Bonds are Tax free, hence issue of  Tax deducted at Source(TDS) does not apply.
• These bonds will be eventually listed on the Bombay and/or National Stock Exchange,
• These bonds are available for buying within a specific period during the issue period. After that one can buy from the stock exchange on which they are listed.
• Investors can sell  before the full term of the bond as they are listed on Stock exchanges(BSE,NSE). However, the price you may get for selling before they mature will depend on market conditions. And one would also need to pay capital gain.
• If sold on exchanges (secondary market) any capital gain from sale is taxable. As they belong to debt category  indexation benefit is available. If sold within one year one has to pay Short term Capital Gain at the normal rate, while long-term capital gains are usually taxed at 10% without indexation and 20% with indexation.   Indexation is adjusting the purchasing price with inflation measured by inflation index. However as per third proviso to Section 48 of Income Tax Act, 1961 benefits of indexation of cost of acquisition under second proviso of section 48 of Income tax Act, 1961 is not available in case of bonds and debenture, except capital indexed bonds. Thus, long term capital gain tax can be considered 10% on listed bonds without indexation. (Shiv’s comment and  Taxguru HUDCO – Tax Free Bonds – Tax Benefits).
• Wealth-tax is not levied on investment in bond under section 2(ea) of the Wealth-tax Act, 1957.
• At times Bonds have Step down feature which means that when you buy them from the secondary market, you get a slightly lower rate of interest than the primary subscriber.