Going by nomenclature, tax-free bonds sound like any of those common tax-saving products, but they are not. You can't claim income-tax benefits on the investment you make in these bonds. What is tax-free here is the interest income you earn on these bonds.
These bonds are long-term in nature, with maturities ranging from 10 years to 20 years. But since they are listed, they can easily be traded on the secondary market for deccent profits. The government has mandated that at least 70 per cent of the money raised through such bonds be through public issue out of which 40 per cent should be reserved for retail investors. The maximum interest allowed to offer on these bonds is 50 basis points less than the interest or yield on government securities prevailing at the time of the issue. Entities that are rated below AAA can offer slightly higher interest but still it will be below the yield on government bonds. That way, the rate offered is as such not eye-popping. But the tax-free status of the return is usually a big draw.
Besides, the risk-free nature of these bonds is a good attraction. Besides the attractive tax-free interest income, what drives investors’ interest in these bonds is the quick gains they can expect on this instrument on short-term exit. In a falling interest rate environment, these bonds tend to command high premium in the secondary market due to high yield they offer compared with the prevailing yield in the secondary market and short-term investors make a killing on them.
Valuation of these bonds are determined by the overall economic scenario. When interest rates start to ease, prices of these bonds rise, thereby increasing the yield for existing bond holders. Yields in the debt market keeps changing every day, and in such a situation even a little softening will lead to rise in value of these bonds.
This is why these fresh issuances of tax-free bonds often list at a premium to their face value on the bourses pretty much like initial public offerings in the equity market, allowing great opportunities to investors to make a quick gain.