No taxes on returns from these bonds!

The yields of the US government bonds are touching record levels.  The yield on 10-year government bonds in India has also touched 7.3% in recent months. The rising yields on these bonds, which are also tax-free, has  attracted droves of investors towards it.

Are you also wondering what tax-free bonds are, and whether you should invest in them? Let’s understand.

Before we move ahead, investors need to understand two things. First, what is a coupon rate, and second, what is yield or yield to maturity.

Coupon rate is the predetermined rate of return you get on the face value of the bond. And, if you buy a bond from the market, the return you will receive from that time till the bond matures is called yield-to-maturity.

Generally, you can buy bonds at a discount, or at a price less than its face value in the open market.

Now, let’s understand what do tax-free bonds mean.

Tax-free bonds are a type of fixed income securities launched by the government or government companies, which guarantee return. The interest received on these bonds is tax free. This interest is given on the basis of the coupon rate of the bond. Once the bond matures, the principal amount is returned to the investor.

You can also buy and sell these bonds at market rates in the open market.

But the capital gains you earn on buying or selling bonds in the open market will be taxed. The tax applicable will be the slab under which the individual falls for income tax purposes.

Bonds can be stored either in physical or in dematerialised form. These bonds usually come with a long-term maturity period, ranging from 10, 15 or even 20 years. These bonds can prove to be a good source of regular income. This is because you earn interest on these bonds, either semi-annually or annually.

There are no risks involved in such tax-free bonds, given that they are issued  by government companies, Usually, these bonds are rated AAA.

No TDS is deducted on its returns or interest, which means you do not have to pay income tax.

Liquidity is also easy in these because they can be bought and sold in the market anytime through Demat account.

Now, let us understand who should invest in tax-free bonds?

These bonds are beneficial for people who are in higher tax brackets, that is people in the 30 percent tax bracket. Currently, the returns are in the range of 8-9 per cent. This return is better than bank FDs.

A return of 8% in an FD translates to only 5.5% after taxes.

Tax and investment expert Balwant Jain says that tax-free bonds benefit only people in higher tax brackets. If such bonds fall in a higher interest rate cycle then it provides a higher coupon rate. In such a situation, it can provide some additional benefits for investors.

Bonds are not very profitable if bought from the open market because they are available at expensive prices which reduces your effective yield, Jain says.

If we talk about tax-free bonds available now, then bonds of IREDA, NHAI and PFC can be good options for investment.

(Disclaimer:  Recommendations by experts or brokerages are their own and not those of the website or its management. Money9.com advises readers to check with certified experts before taking any investment decisions.)