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Why Should You Invest In Tax-Free Bonds?

Author: Balwant Jain/Wednesday, November 11, 2020/Categories: Exclusive

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Why Should You Invest In Tax-Free Bonds?

One of my friends, who had already decided to invest his retirement savings in such a way so that he doesn't have to pay any tax after his retirement. So, he wanted to invest in tax-free bonds,  had called me to know about the tax-free bonds available. I discussed the matter threadbare with him to understand why he was adamant to invest his retirement funds in tax-free bonds so that he doesn't have to pay any tax. This article is the result of discussion I had with him.

What are tax-free bonds and how these are priced?

Entire interest income received by you whether from banks or bonds of various companies are taxable in your hands. However, the interest received on certain bonds issued by Government enterprises and as notified under Section 10 is tax free. These bonds were issued a few years back to help government enterprises raise funds, but now-a-days such bonds are not issued. So, your only option to own such bonds is to buy them from the open market. The bonds have an issue price, which is generally its face value. The bondholder gets interest on bonds at the rate specified at the time of issue of the bonds. This rate is called coupon rate, which generally remains the same during its tenure.

Since the interest rates keep on changing depending on various factors. The bonds though are issued at face value, but once these are issued these are not traded at face value. These bonds are either traded at discount or at premium depending on whether the market interest rate is lower or higher than the coupon rate of such bonds. In case of tax-free bonds the market price of such tax-free bonds has inbuilt the fact that interest on such bonds are tax free and therefore such bonds are priced at higher than the taxable bonds. So, the yield on such bonds is lower than other products like fixed deposits or other bonds of same level of safety.

Who Should Invest In RBI Bonds And Who Should Invest In Tax Free Bonds?

Just because interest on such bonds is tax-free in your hands, it doesn't mean that you should buy them blindly. These bonds are for very long period and are not so frequently traded and therefore are not as liquid as other investments. So, in case you need money urgently, you may have to sell them at lower than the price you should get in normal circumstance.

The present yield on AAA rated bonds of government enterprises is around 4.90-5 per cent. Against these tax free bonds individual investors have an alternative option to invest in equally secured product i.e. RBI Floating Rate Savings bonds. The RBI bonds presently offer you interest rate of 7.15 per cent, which is floating and is fixed every six months and is benchmarked against interest rate payable on National Saving Certificates (NSC). So, as and when the interest rate cycle reverses the interest payable on such RBI bonds will also go up.

Looking at the rate of interest offered by the banks on their fixed deposits, the only risk free products available for a layman individual investor is the RBI floating rate savings bonds. However, since the interest on these bonds are taxed at the slab rates, post tax net interest in the hands of individual is tabulated for persons in different tax slabs. Though the basic exemption limit still remain Rs 2.50 lakhs, but due to rebate available under Section 87A all the taxpayers with taxable income below Rs5 lakhs don't have to pay any tax. Hence, people in the income group upto Rs5 lakhs have been clubbed under zero tax rate group. 

From the above table, it becomes apparent that  post-tax return on the RBI bonds is lower as compared to the yield on tax free bonds for persons with income higher than Rs10 lakhs. So, for those with taxable income upto Rs 10 lakhs, it doesn't make sense for them to invest in tax free bonds. Even if we take into account the brokerage charges payable on purchase of these bonds, I feel even the cut off limit for investments will go higher to those with income over Rs50 lakhs. The interest rate offered by RBI bonds is externally linked to NSC. It is perceived that the interest rates have reached their bottom except for maximum one or two small rate cuts so the interest rate cycle will reverse sooner than later. Once the interest rate cycles reverses, the coupon rate on these bonds will go up and post tax yield will also go up.  So, in case you wish to invest your money for seven years and your income doesn't exceed Rs50 lakhs, then it makes sense for you to put your money in RBI bonds than going for tax-free bonds just to have no tax liability taking into account the indicative yields and probability of interest rates going up in near future.

After the detailed discussion my friend was convinced and threw away the idea of investing his retirement savings in tax free bonds as his income post retirement was not going to exceed the threshold of Rs50 lakhs.

The writer is a tax and investment expert and can be reached on jainbalwant@gmail.com

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