What are Bonds?
A bond is a financial instrument issued by an entity (generally corporate or governmental) which is looking to borrow funds for a defined period of time at a fixed or variable rate of interest to finance its projects and activities.
When an investor buys a bond he/she becomes a creditor to the issuer and has the right to receive an interest usually on fixed intervals based on the mentioned coupon rate (the rate used to determine the periodic interest to be paid on the principal amount) . The investor also has the right to get back his principal at a later date, termed the maturity date .
The contract between the borrower and the lender known as bond indenture specifies all the rights and obligations of the issuer and owners of the bond and forms the basis for all future transactions. The contract provisions are known as covenants and include both negative covenants (prohibition on the borrower like restriction on assets sales that has been pledged as collateral, restriction on additional borrowings unless certain financial ratios are met) and affirmative covenants (actions that the borrower promises to perform like timely payment of principal and interest, maintenance of certain financial ratios, etc).
It should be noted that a buyer of bond does not gain any kind of ownership rights to the issuer, unlike the case of equities but have a greater claim on an issuer’s income than a share holder in the case of financial distress of the issuer.
Bonds are generally divided into different categories based on its tax status, credit quality, issuer type, maturity, etc.
Tax Free Bonds
Tax free bonds are those in which the interest earned by the bond holders is exempted from taxes under the Income Tax act of 1961. The interest received by the bond holders does not form part of his/ her total income. But no tax deduction is available on the invested principal amount. These bonds are generally issued by Government backed entities.
Tax free bonds are suitable for investors who require a steady source of income and can afford to lock-in their capital for long term.
Features of Tax Free Bonds
- Tax free bonds generally have a long term maturity period of 10, 15 or 20 years.
- The proceeds from these bonds are commonly invested in infrastructure projects.
- As tax free bonds are generally issued by government backed companies, the risk of non-repayment to the bondholders remains practically negligible.
- The interest rates offered by the tax free bonds are linked to the prevailing rates of government securities.
- As the interest received on these bonds are tax free, investors get higher post tax returns as compared to fixed deposits.
- The interest is generally paid on an annual basis.
- The bonds are issued both in physical and demat form.
- Tax free bonds are listed on the stock exchange and subsequently allow trading on the same offering an exit route to the existing bond holders. However, these bonds do not enjoy very high liquidity.
- Any gain that accrues out of selling these tax free bonds in the secondary market is termed as capital gains and is taxable. Short term capital gains (selling before three years from the date of purchase) on selling the tax free bonds are charged at the marginal rate of taxation of the bond holder whereas in case of long term capital gain (selling after three years from the date of purchase) it is taxed at 10% without indexation and 20% with indexation. Indexation assists in adjustment of the purchasing price on the backdrop of annual inflation.
Tax Free Bonds are on offer
Currently No Tax Free Bonds are on offer!!