As the financial year draws to a close, several public sector companies have launched tax-free bonds offering 8.8-9% interest over a tenor of 10-20 years. These bonds are an ideal instrument for risk-averse retail investors. Though the investor does not get any tax exemption under Section 80C of the Income Tax Act, 1961, the interest accrued is completely tax-free under Section 10(15)(iv)(h).
Retail investors can invest a minimum of R5,000 and a maximum of R10 lakh in these bonds, and they get an additional 25-basis point interest compared to high-net individuals and institutional investors. Retail investors are defined as resident individuals or HUFs who invest up to R10 lakh across all series of bonds in each tranche. An individual can invest in more than one company and still be in the retail category. The bonds can be issued in the demat as well as physical mode.
Only public sector companies can issue these bonds. In 2013-14, the government has allowed 13 public sector companies to raise up to R50,000 crore from tax-free bonds. The proceeds are invested in infrastructure projects. Retail individual investors, qualified institutional buyers, companies and high net-worth investors can invest in these bonds in varying proportions.
Analysts say tax-free bonds are an attractive long-term investment as the government, in the interim budget for 2014-15, did not allot tax-free bonds to state-owned companies for the next financial year. Moreover, the volatility that the equity markets are experiencing has drawn retail investors to these bonds.
There will be no deduction of tax at source (TDS) from the interest, which accrues to the bondholder irrespective of the amount of the interest or the status of the investor. Moreover, wealth tax is not levied on investments in these bonds under Section 2 (ea) of the Wealth Tax Act, 1957.
The Indian Railway Finance Corporation (IRFC) has extended the closing date for its public issue of tax-free bonds to March 14. Similarly, the tax-free bonds of Housing and Urban Development Corporation (HUDCO) will close on March 19.
At present, National Housing Bank is offering the maximum interest rate of 8.93% for a tenure of 15 years while IRFC is offering a maximum coupon rate of 8.88% for a tenure of 15 years.
This financial year, investors have been choosing tax-free bonds because of a higher interest rate than last year. Tax-free bonds usually pay lower interest than corporate bonds as the former has a better credit rating and the interest received is tax-free.
While the interest offered on tax-free bonds is similar to that on five-year bank deposits, the bonds carry an advantage because of tax exemption on the interest earned. While post-tax returns on a bank fixed deposit range between 6 and 7%, tax-free bonds give annual returns between 8.5 and 9%.
However, bank fixed deposits score over tax-free bonds in terms of liquidity as these bonds have a longer maturity and are not easy to sell in the secondary market.
All tax-free bonds are backed by the government. So, the credit risk (risk of non-repayment) is very low. While HUDCO is rated AA+ by CARE Ratings, NHB is rated AAA by Crisil, CARE and ICRA. For most tax-free bonds, the allotment is on first-come, first-serve basis.
The interest on these bonds is paid annually, credited directly to the investorís bank account. The annual interest payout is a good option, especially for those with a steady post-retirement income.
Financial planners say long-duration bonds reduce re-investment risk and, as interest rates may come down in the long term, it is wise to lock in the high rates these tax-free bonds are offering. For investors in higher tax brackets, these bonds are an attractive option as they can significantly lower the tax outgo.
Retail investors can even book profits by selling these bonds, but will have to pay short-term capital gains tax. The proceeds from the sale will be taxed as normal income, and long-term capital gains will be taxed at 10%. The bonds must be held for at least 12 months for the profits to be treated as long-term gains. Moreover, long-term capital gains from these bonds are not eligible for indexation benefit.
Analysts say investors should look at the size of the issue as the bigger the amount, the higher is the probability of good volumes after listing. Once the issue is listed, investors can sell these bonds on stock exchanges or even buy more of them.