These bonds are having Tax Benefits Under Section 10(15)(iv)(h) of the Income Tax Act, 1961. According to which the Interest income earned would not be included in to the total income and hence no Tax liability.
Bonds form the part of “Debt” as an asset class. This implies that the investor has given a loan to the issuing entity, and will be repaid at the end of the tenure as specified.
Tax free bonds have emerged as highly popular investment option among investors due to the taxation benefit that they offer. These bonds, generally issued by government backed entities, are exempt from taxation on the interest income received from such instruments under the Income Tax Act, 1961. However these bonds do not offer any additional taxation
Tax-exempt bonds usually pay lower coupons than corporate bonds as they enjoy a better credit rating and the interest received is tax-free, thus after-tax returns work out to be higher for the tax-exempt bond.
Investors get carried away by the effective yield on tax-free bonds. The effective yield is calculated as follows:
Effective yield = coupon rate/ (1-tax rate). Hence, for a coupon of 8.2%, an investor in the 30.9% tax bracket has an effective yield of 11.86%. The cash flow in the hands of the investor is only Rs 8.2 for every Rs 100 invested in the bonds, and the reason the yield is shown higher is due to the tax rate. Change in tax rate will change the effective yield on the bonds.
Effective yield is only relative in nature, not absolute. If the comparison is between investing in a ten-year fixed deposit of an AAA-rated bank at 8.2% which is taxable and investing in a ten-year maturity tax-free bond at 8.2%, then effective yield can be used as a measure for comparison. Investors can substitute tax-free bonds for fixed deposits as post-tax return is much better on tax-free bonds.
Investors wanting to park surplus funds in an asset that will give them an absolute return of 8.2% every year for ten years, or 8.3% every year for 15 years, irrespective of the returns available elsewhere, can invest in tax-free bonds. In such cases investors are content with the returns offered and have surplus money that can be locked in for ten or 15 years.
Details of Taxfree Bonds