Should you invest in tax free bonds?

The interest earned on tax-free bonds is exempted from taxation. But, the bonds are subject to capital gains tax

February 06, 2013 10:34 IST | India Infoline News Service
Tax free bonds are back in vogue. Many public sector companies have launched their tradable tax free bonds recently, while a number of PSUs are likely to launch tax free bonds soon. Power sector lender Rural Electrification Corporation (REC), Power Finance Corporation (PFC) and India Infrastructure Finance Company Ltd (IIFCL) launched tax free bonds in December 2012.

Bond is a debt investment in which an investor loans money to a corporate or government organisation that borrows the funds for a defined period of time at a fixed interest rate. The major difference is that the principal amount in bonds is not guaranteed, except at the time of maturity. If you sell the bond before maturity, you may get an amount less or more than the investment amount.

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually).

Retail individual investors, qualified institutional buyers, corporates and HNIs (high net worth individuals) are eligible to subscribe to these bonds. It is mandatory for the subscribers to furnish their permanent account number to the issuer/company.

Bank FDs can be made at any time, but investment in new tax-free bonds can be done only at a specific time—when the issue is open for subscription. These bonds are tax free under Section 10(15)(iv)(h) of the Income Tax Act, 1961. According to Section 10(15)(iv)(h), computing the total income of a previous year of any person, interest payable by any public sector company on such bonds will not be included. Since the interest income on these bonds is exempt, no tax deduction at source is required on the same.

Normally, the interest is paid out annually. The mode of interest / refund / maturity amounts is done through direct credit, cheques, demand drafts, national electronic clearing scheme (NECS) or real time gross settlement (RTGS).

Being tax-free, the returns on the bonds are higher than the post-tax return on bank deposits. Usually, the highest interest rate offered on bank FDs (fixed deposits) from one to five years tenure is 9.5% per annum. However, the interest earned on these FDs is mostly taxable. The interest earned on tax-free bonds is exempted from taxation. But, the bonds are subject to capital gains tax.

Under Section 2 (29A) of the I.T. Act, a listed bond is treated as a long term capital asset if the same is held for more than 12 months immediately from the date of its transfer. Though these bonds are listed on the stock exchanges, securities transaction tax (STT) is not applicable on transactions in the bonds.

Short-term capital gains on the transfer of listed bonds, where bonds are held for not more than 12 months are taxed at the normal rates of tax in accordance with the provisions of the I.T. Act, 1961. Wealth-tax is not levied on investment in these bonds.

The tax free aspect of the instrument makes it highly attractive for individuals from the higher tax bracket or for corporates. Tax-free bonds are issued mostly by public sector entities. These bonds are issued with the purpose of raising funds for infrastructure development by the government. Since it is backed by the government of India, these bonds are mostly highly rated. The bonds are listed on stock exchanges and thus provide liquidity, whereas fixed deposits have to be surrendered to the bank. The bonds will help save good money, while paying a fixed rate of interest for the long term. 

Individuals and HUF (Hindu Undivided Family) through Karta investing up to Rs. 10 lakh will be considered as retail investors. Since these bonds are issued by public sector entities, they are normally safe instruments for retail investors to park their money. However, one also needs to also check the credit ratings given by CRISIL or ICRA. Once listed on Bombay Stock Exchange, the bondholder can also sell his bonds to other investors. 

Once a retail investor sells or transfers bonds which have been originally allotted at issue, interest rate will fall marginally—i.e. the buyer will earn 50 bps (basis points) less. Thus, the higher rate of interest, applicable to retail investors, would not be available in case the bonds are transferred, except in case of transfer to legal heir in event of death of the original investor.

Tax free bonds for retail investors come with a maturity period from 10 to 15 years. One can sell the bonds in a demat form after the completion of the lock in period. However, demat account is not necessary to invest in these bonds. Investors have the option to apply these bonds in physical form. In case of bonds applied for in physical form, the investor/applicant will get a consolidated bond certificate. The company/issue will dispatch the bond certificate to the address of the applicant provided in the application form.

Where bonds are held in joint names and one of the joint-holders dies, the survivor(s) will be recognised as the bondholder(s). Nomination facility is available. The appointment of a nominee leads to less complications at the time of claim in the event of the death of the bondholder. 

Generally, the bonds will be listed within 15 days of closing of issue on both NSE and BSE, and there is no lock in on them so you can trade them in the secondary market immediately after listing. But, one needs to read and understand the terms & conditions mentioned on the Application Form before investing in an issue. As different companies may have different rules of listing.

Premature withdrawal of FD will give the principal back along with interest calculated at the interest rate for the period minus 1%. However, the principal amount for bonds is not guaranteed except at maturity. Tax free bonds are good investment option for people falling in 20% or 30% tax bracket.

When you invest in a tax-free bonds of any issuer, you are giving a loan to that issuer and in return the company pays you interest each year. Assume, PFC will lend to power projects of third parties. If these loans turn into NPAs (non performing assets), then it could hugely affect the repayment capacity of the company. Hence do not over invest your hard-earned money into these bonds.

Indian Railway Finance Corporation (IRFC) also plans to raise nearly Rs. 90 billion through tax-free bonds by March 2013. The company said that bonds would be issued in one or more tranches through non-convertible debentures (NCD) route, according to the draft prospectus filed with SEBI (Securities and Exchange Board of India).

Like FDs and tax-free bonds, companies use NCDs as another route to raise capital. For investors, an NCD is therefore yet another investment option available on the debt side. NCDs are rated by agencies such as CRISIL, ICRA or CARE.

Whenever a company wants to raise money from the public it issues a debt paper for a specified tenure where it pays a fixed interest on the investment. This paper is known as a debenture. Some of the debentures are termed as convertible debentures since they can be converted into equity share on maturity. An NCD do not have the option of conversion into shares and on maturity the principal amount along with accumulated interest is paid to the holder of the instrument. It usually carries a higher interest rate than a convertible debenture.

NCDs can either be ‘secured’ or ‘unsecured’. Secured NCDs are backed up by some assets which can be liquidated for paying off the bondholders if the company faces financial crisis.

Unsecured NCDs are comparatively riskier. They are not backed by any assets and in case if the company faces financial crisis, there can be an issue in paying back the bondholders. To compensate for the higher risk they offer a higher rate of interest compared to the secured NCDs.

India Infoline Finance, Shriram Transport Finance Company, Shriram City Union finance, Religare Finvest, Muthoot Finance and Srei Infrastructure Finance have launched their NCDs.

A number of tax free bonds are expected to be introduced soon. HUDCO (Housing and Urban Development Corporation Ltd) is also planning to launch a public issue of tax free bonds soon.

In the budget for FY12-13, the government proposed raising Rs. 600 billion through tax-free infrastructure bonds. However, the notification that came out last month slashed the amount by Rs. 65 billion. In FY11-12, the government-run infrastructure entities raised a total of Rs. 300 billion through these bonds. National Housing Bank, Ennore Port, Jawaharlal Nehru Port and Dredging Corporation are among companies permitted by the government to sell tax-free bonds this year.

General instructions
  1. If the allotment of the bonds is in dematerialsed form, ensure that the details about depository participant and beneficiary account are correct and the beneficiary account is active. In case the application form is submitted in joint names, ensure that the beneficiary account is also held in same joint names and such names are in the same sequence in which they appear in the application form.
  2. Any application form without the PAN is liable to be rejected.
  3. Applicants should write their names and application number on the reverse of the cheque by which the payments are made.
  1. Do not pay the application amount in cash or by money order.
  2. Do not send the application forms by post; instead submit the same to the members of the syndicate, SCSBs and trading members (as the case may be) only.
Documents needed
  1. Duly filled application form
  2. Self-attested copy of the PAN card;
  3. Self-attested copy of your proof of residence
  4. Anyone of the following documents will be considered as a proof of residence:
  5. Ration card
  6. Driving license
  7. Electricity bill (not older than 3 months)
  8. Landline telephone bill (not older than 3 months)
  9. Passport
  10. Voter’s identity card
  11. Passbook or latest bank statement
  12. Aadhaar card

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