Tax-free bonds carry lower credit risk as the entities are backed by the government
Interest earned from tax free bonds is simply tax free
Tax-free bonds that were issued by central government enterprises between FY12 and FY16 remain a good bet for earning regular, tax-free income. They are particularly attractive for investors in higher tax brackets. Unlike other fixed income instruments like bank fixed deposits (FDs), the interest earned from tax- free bonds is simply tax free. The interest on the bonds is paid annually into the account of the investor.
These bonds carry lower credit risk as the entities are backed by the government. Tax-free bonds have a lock-in-period but bondholders can redeem them before the maturity date as they are listed on stock exchanges. Investors can buy and sell them through demat accounts.
"Post IL&FS default, it is prudent to invest in securities that are issued by central government or public sector enterprises," says Vikram Dalal, managing director of Synergee Capital. "We suggest short maturity tax-free bonds. The bonds are listed on the stock exchanges and are available in secondary market as well."
"Banks are offering fixed deposit at 6.25%-6.75% interest rate. Considering those who are in the 30% tax bracket, their post tax return will be 4.25-4.50%. On the other hand, tax free bonds are available at 5.65-5.72% YTM (return on investment). Interest earned on this security will be tax free," he says.
For example, the 8.10% tax-free HUDCO Bonds 2022, date of issue of 05/03/2012 and maturing in March 2022, trades at ₹1,114, giving a yield of 5.72%. Remember, bond prices and yields move in the opposite direction.
Apart from the maturity date and coupon rate, the investors should also look at the credit rating, yield to maturity and liquidity.
Capital gains, if any, from sale of these bonds are however taxed. If sold before one year, the gains are treated as short-term capital gains and they are added to the income and taxed as per the applicable income tax slab. If investments are held for more than one year, gains qualify for long term capital gains tax of 10% without indexation benefit.