Home/Article/What are tax-free bonds and how they work
What are tax-free bonds and how they work
05 Jan 2023

Tax free bonds have been the flavour 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, IREDA, 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. 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 2007 for Rs.55 lakhs at Rs.1.20 crore in 2017, then you can avoid paying the capital gains on these bonds by reinvesting the entire Rs.1.20 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?
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 depostis (FD) that would not have the hassle of lock-in periods and can also be monetized at short notice in a much easier manner.
Why not look at debt funds as a better option..
Debt is intended to meet your basic needs for stability and assured returns. A better choice will be opt for debt funds instead. It proffers quite a few advantages. Firstly, the dividends that you opt for will be entirely tax-free in your hands. Secondly, debt funds are liquid and you can monetize your debt funds at very short notice and realize funds in less than 2 days. Thirdly, investors do worry about default risk and interest rate risk. We will look at interest rate risk separately, but default risk can be overcome by focusing on G-Sec funds that are entirely risk-free. Lastly, let us come to the aspect of interest rate risk. In the current economic context, the rates have held a downward trajectory and therefore rates should work in favour of debt funds. When rates fall in the market, debt funds see an appreciation in their NAV and therefore investors earn the interest plus the capital gains. That is a benefit that is not available in case of even tax-free bonds.
To conclude, while it is easy to get carried away by the apparent attractiveness of tax-saving bonds, you need to get the arithmetic right. Evaluate the options and then take a final call on investing in these tax-free bonds!

Checkout more Blogs

You may also like…

Get Exclusive Updates

Be the first to read our new blogs

Get Expert financial insights and advice for informed investment decisions.

Intelligent investment insights delivered to your inbox, for Free, daily!

Take your next step

Open Demat Account
I wish to talk in South Indian language
By proceeding you’re agree to our T&C