Currently, most tax-free bonds are offering a yield higher than 5 per cent and comes with liquidity as they are available on a stock exchange.
Tax-free bonds are free from the obligation to pay the income tax on the interest income earned. Investors investing in tax-free bonds are not required to pay tax on the half-yearly or annual interest payments and there is no tax liability on the principal amount received on the maturity.
Simply put, a tax-free bond is almost similar to a fixed deposit when it comes to the investment. A lump sum can be invested in a tax-free bond that carries a fixed rate of interest for a fixed term. On maturity, the principal is returned back to the investor. However, there are certain other unique features in a tax-free bond such as face value, coupon rate or yield etc. Also, unlike bank deposits, tax-free bonds are listed and traded in stock exchanges.
Tax-free bonds suit investors in the highest tax slab paying 30 per cent tax on taxable investments such as bank fixed deposits. For someone paying 31.2 per cent tax including surcharge invests in a 7 per cent deposit, the post-tax rate is about 4.8 per cent.
Some of the tax-free bonds as in the table below are currently available at a yield of above 5 per cent.
The face value of a tax-free bond is usually Rs 1000. On the stock exchange depending on interest payment due date or the movement of interest rate in the economy, it can be traded at a discount or premium to its face value. For example, a Rs 1000 bond can be available in the market at Rs 980 or at Rs 1120.
The coupon rate is the fixed rate of interest that the bond carries. It determines how much interest income will be received by the investor. For example, even if an investor has purchased Rs 1000 bond carrying a coupon rate of 7 per cent per annum interest, at the market price of Rs 1120, the interest payment of Rs 70 is received by the investor.
But, the investor had purchased the Rs 1000 worth bond at a higher price of Rs 1120. Therefore, the actual yield or return will be lower. To calculate yield, one can use the formula:
Yield = (Annual interest received as per Coupon rate / Face value of bond) * 100
= (70 / 1000)*100 = 6.25 per cent
When the purchase price is high, typically the yield will be low compared to the coupon rate. The interest income received based on the coupon rate will, however, be tax-free in the hands of the investor. The maturity date is also an important factor to look at while investing in them. If you wish to sell it before maturity, the gains, if any, will be subject to capital gains tax.