Tax-Efficient Investing: Leveraging Bonds for Better Returns and Lower Liabilities
Bonds can form a prudent investment choice, especially for those looking to create a steady source of income. However, most bonds aren’t tax-free. The periodic interest you earn on them is taxable. So, taxes can eat up a significant portion of your returns! Nevertheless, not all bond investments are taxable. Thanks to the Indian investment horizon, you can choose from a range of tax-efficient bonds to curb or eliminate the tax impact. Thus, if you also endeavour to make a tax-efficient investment, here’s a blog you shouldn’t miss reading.
What is a Tax-Free Bond?
Tax-free bonds, like other bonds, are debt instruments that the Indian government or its authorised entities like public sector undertakings (PSU) and infrastructure companies issue to call upon investments. As the name suggests, these bonds offer tax-free interest income. So, that means the interest you earn on such bonds is not subject to income tax deductions in India.
Types of Tax-Free Bonds
Since tax-free bonds are issued by government-related organisations, some common types of tax-free bonds, based on the issuer, include the following.
- Power Bonds: Power generation companies looking for operational expansion or requiring funds to maintain power plans issue these bonds.
- Infrastructure Bonds: Infrastructure companies building airports, roads, etc., issue these bonds to fetch finance for large-scale projects.
- Public Sector Unit Bonds: Government-owned entities or organisations like HUDCO, NTPC, NHAI, REC, PFC, etc., issue these bonds to fund infrastructure, power, and housing projects.
- Railway Bonds: As the name suggests, the issuer of these bonds is the Indian Railways. The objective of gathering money through these bonds is to finance the expansion and modernisation of the Indian railway network.
- Housing Bonds: Entities like the National Housing Bank issue these bonds to finance economical housing projects across the country.
Features of Tax-Free Bonds
Tax-free bonds form a potentially lucrative proposition for the following reasons that also constitute their features.
- Tax Exemption: The foremost advantage or feature of tax-free bonds is that the income you earn from these bonds is exempt from income tax. So, if you are looking to potentially maximise returns and minimise your tax liabilities, you may choose to invest in tax-free bonds.
- Fixed But Higher Interest Rate: Tax-free bonds have a fixed rate. However, it is higher than many other regular fixed-incomeinstruments. Usually, the annual interest rate can range between 5.50 and 7.50 per cent. Nonetheless, one must note that the interest rate may vary based on the issuer and the prevailing economic environment.
- Minimum Investment Requirement: Usually, tax-free bonds require a minimum investment of Rs. 1,000. However, the requirement may differ depending on the issuer. On the other hand, they have a higher maximum investment. Investors can invest lakhs or even crores of rupees, depending on their investment capacity. No wonder tax-free bonds are a popular choice even among high-net-worth individuals (HNIs).
- Longer Maturity Period: Tax-free bonds usually have a longer maturity, ranging from a decade to two. Hence, they can form an apt choice for people looking to make long-term investments.
- Tradability: You can trade tax-free bonds in the secondary market. So, as an investor, you will have liquidity and an exit option.
- High Credit Rating and Low Risk: The issuers of tax-free bonds are government-backed organisations. Hence, they have a high credit rating. However, that also makes these bonds low-risk investment options.
- Lock-In Period: Tax-free bonds have a lock-in period. Hence, you cannot redeem them before maturity. This, in particular, may work to your disadvantage, especially in situations when you are in dire need of funds. This is where diversification of investments plays a role, though.
- Non-Convertibility: You cannot convert tax-free bonds into the equity shares of the issuing organisation. Hence, one may find them a little disadvantageous, especially on the convertibility front.
How to Invest in a Tax-Free Bond?
Investing in a tax-free bond is a pretty straightforward process. Here’s how you can invest in a tax-free bond.
- Open a Demat account with a bank or with a depository participant (DP).
- Research and choose the right tax-free bond that aligns with your investment objectives and risk-taking capacity.
- Check the issuer’s eligibility criteria and ensure you meet them. Usually, individuals, Non-Resident Indians (NRIs) and Hindu Undivided Families (HUFs) can invest in these bonds.
- Once you open the Demat account, you can invest in a tax-free bond that matches your financial objectives. You can apply for it via AltiFi.
- Transfer the invested amount from your bank to your Demat account.
- After that, you will receive an email confirmation or a physical bond certificate. The form of confirmation will vary depending on the issuer.
Once you invest successfully, you will start receiving periodic interest payments per the bond’s terms and conditions. You can monitor your tax-free bond investment in your Demat and trading accounts.
Factors to Consider Before Investing in a Tax-Free Bond?
Investing in a tax-free bond can seem a lucrative proposition. However, before you do so, you should consider a range of factors, including the following.
- Lock-in Period: During the lock-in period, you cannot redeem or sell the tax-free bond. Hence, before finalising a tax-free bond, check if the lock-in period aligns with your investment goals and horizon and liquidity requirements.
- Interest Rate: Compare the interest rates that various issuers and gauge their suitability per your investment objectives.
- Credit Rating: Tax-free bonds are usually low-risk bonds. Nevertheless, that doesn’t mean you invest blindly in any bond. You should still evaluate the issuer’s creditworthiness. As a general rule, high-rated issuers offer lower yields However, they have a low credit risk.
- Liquidity: In addition to the above, evaluate the tax-free bond’s liquidity in the secondary market. Tax-free bonds are typically less liquid than stocks or government securities. Hence, you should ensure that you can access the bond’s liquidity, if needed, before its maturity.
- Callable Feature: Some tax-free bonds may have a callable feature. It means the issuer can redeem the bond before its maturity. As an investor, though, you should know the implications of the callable feature concerning your investments and the reinvestment risk associated with it.
- Yield and Inflation: Even if the interest you earn is tax-free, you should calculate the tax-free bond’s actual yield after adjusting the inflation rate. It shouldn’t happen that the inflation rate outscores your yield.
- Costs: Although exempted from taxes, tax-free bonds may still have transaction costs, brokerage fees, or other expenses with buying and holding them. These costs can negatively impact your return on investment.
Broaden Your Investment Scope with Bonds – Invest Through AltiFi!
Ideally, everyone would want to invest in tax-free bonds. Hence, tax-free bonds remain in high demand, especially during the tax-saving season. However, the supply of such bonds is low. Hence, the sooner you analyse and decide to invest, the better. Sign up with AltiFi and monitor our listings to invest in a bond before it closes. Thousands have already invested with us. So, why not you? Join the AltiFi family and diversify your investment portfolio with us.
Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.