The hidden benefit in Tax-Free Bonds

The hidden benefit in Tax-Free Bonds

Last updated: 06 Jul, 2020 | 05:46 pm

The hidden benefit in Tax-Free Bonds
Tax-free bonds are bonds that have a special section in the Indian Income-tax Act where the coupon or the principal of the bond or both are exempted from taxation. 

Benefits of Tax-Free Bonds:
  • They are issued by a handful of PSU companies that are operated and backed by the government of India. 
  • These have the highest credit rating possible of AAA. Therefore, they have extremely low credit risk.
  • The yields are less volatile compared to the yields of corporate bonds.
  • They have very high liquidity.

But most tax-free bonds are currently trading at a Yield to maturity (YTM) of ~4.5%. Why invest in a bond at such low yield?

If you are in a high tax bracket, then you definitely must.

Let’s understand how this is beneficial for you! 

Below is an example of an investment of 1 Cr in a HUDCO Tax-Free Bond vs a HDFC Bank Bond with similar maturity dates

  • So your interest earned is significantly higher in the tax-free bond. 
  • However, given the price paid for the bond, you do make a capital loss when the bond matures.
  • So you make a higher capital loss at maturity in the tax-free bond although in total you earn higher
  • However, the key upside in booking a capital loss is that it can be used to offset capital gains you make on other investments across equity, debt, gold or real estate!
  • This gives you an extra benefit that can be carried forward for 7 years.

Summing up:

  • HUDCO Bonds offer nearly ₹6 lakh tax-free every year. This is an excellent option for investors in the highest tax bracket of 42.7%, as there is no other instrument with the same level of safety offering such a high yield.
  • In addition to the higher amount you earn on interest received, you also can use the capital loss to offset gains made elsewhere giving you an extra post-tax benefit.