TAX FREE BONDS

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Tax Free Bonds (Capital Gain Bonds)

Tax free bonds have been the flavor for high net worth investors for the last few years. Towards the end of the financial year, there are large infrastructure players like the IRFC, NHAI, REC and PFC that are permitted to raise funds through the issue of tax-free bonds. These tax-free bonds are a way of the government subsiding the raising of infrastructure capital. In fact, tax-free bonds come in two basic types.

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Let us understand them a little better.

Firstly, there are the Section 54EC bonds where you can get a tax break by investing the proceeds of your sale in these Section 54EC bonds. For example, if you sold your property which you had bought in 2010 for Rs.50 lakhs at Rs.1.50 crore in 2020, then you can avoid paying the capital gains on these bonds by reinvesting the entire Rs.1.50 crore in Section 54EC bonds. The benefit under Section 54EC will be available in the form of making your capital gains tax-free. The interest earned on Section 54EC bonds will be fully taxable in the hands of the investors. Secondly, there are the tax-free bonds wherein the interest paid on the bonds at regular intervals is entirely tax-free in the hands of the investor. So a 6% tax-free bond will have an effective pre-tax return of 8.57% assuming that you are in the 30% tax bracket. Most tax-free bonds are fairly attractive when compared to normal taxable bonds and bank FDs in terms of effective pre-tax returns.

Do Section 54EC bonds make investment sense?

Prima facie, these bonds are heavily in demand from HNIs who find this a good way of saving their capital gains tax. However, there are a few basic things you need to remember about investing in these bonds. The yields on such bonds are much lower than on normal bonds and bank FDs to factor in the tax benefit. Hence it will only make sense if you actually capital gains you need to save tax on. Secondly, to be eligible for a tax break under Section 54EC, you need to invest the entire proceeds and not just the capital gains. That has an opportunity-cost in the form of alternate investment opportunities foregone. So, these bonds are not exactly effective unless capital gains constitute a major chunk of your overall sales proceeds.

A better way to approach this would be calculating your actual capital gains tax payable after adjusting for the indexing benefits of long term holding. If after considering indexing, your total tax payable is less than 10% of the proceeds then it makes sense for you to pay off the tax and invest the proceeds in more wealth creating investments. Alternatively, you can also get the same benefit under Section 54 if you reinvest the proceeds in acquiring another property. Considering the lock-in period involved and the opportunity cost of investing the entire proceeds, the tax saving bond may have limited utility from an investor’s perspective.

Are tax-free bonds a good investment option?

Are tax-free bonds a good investment option?

As discussed earlier, these tax-free bonds entail an investment in an infrastructure driven company which will be eligible to earn tax-free interest. Prima facie, the effective returns are higher than taxable bonds if you consider the impact of taxation. But the lock-in period can be quite a deterrent as your bonds are literally idle in your demat account or in your vault. The key question is whether the lock in period is justified considering that this asset does not exactly create wealth over the long term. The value of the bond remains virtually unchanged. A better choice would be to stick to traditional bonds and Fixed deposits (FD) that would not have the hassle of lock-in periods and can also be monetized at short notice in a much easier manner.

Government bonds: These are the bonds that are issued by the government directly. These are secured as they are back by the Government of India. These bonds generally have a low rate of interest.

Corporate bonds: Corporate bonds are issued by the private companies. These companies issue both secured and non-secured bonds.

Bank and Financial institution bonds: These bonds are issued by various banks or financial institutions. A number of bonds that are available in this segment are from this sector.
Investors can buy these bonds by opening an account with a broker. It is also advisable to check with your financial advisor before making your investment in bonds and to know which one to choose from.

Why investing in Bond is important?

Why investing in Bond is important?

Bonds Investment provides an income stream that is easily predictable and in many cases, bonds pay the interest twice in a year. If the bondholder holds the bond till the day of maturity, the investor gets the entire principal amount and hence, these are considered as an ideal way to preserve one's capital Bonds can also provide the offset exposure to the extreme volatile shareholdings one might have. By investing in bonds, one can expect a steady stream of income even before the maturity in the form of interests.

Calculating the yield and the bond prices

A number of investors find it confusing when it comes to the bond prices and the return one can get via bond investments. A number of novice investors will be surprised to learn that the bond prices change day to day, similar to any other security that is traded publicly.

The yield is the returns one can expect from their investment made in bonds. The simplest way to calculate this is by using the formula; yield is equal to the coupon amount divided by the price. When the bond is bought at par, the yield can be equal to the rate of interest. Thus, the yield changes with the bond price.

Another yield that is often calculated by investors is the returns that they get upon the maturity of the bond. This is a more advanced calculation which will provide the total yield one can expect if the bond is held until the date of maturity.