InvestorQ : What are taxable bonds and tax-free bonds and how does it impact returns?
Sam Eswaran made post

What are taxable bonds and tax-free bonds and how does it impact returns?

swati Bakhda answered.
2 years ago

Here is what is meant by taxable bond and tax free bonds.

Taxable Bonds

Bonds, by default are taxable. Hence all bonds issued by financial institutions and quasi government agencies, unless otherwise specified, are taxable bonds. As we will see in the next paragraph on tax-free bonds, when a bond is tax-free it is specifically mentioned as tax free in the prospectus itself. Taxable bonds are taxed at your peak rates. Many of these bonds are also listed on the exchanges and are tradable in the open market although liquidity can be an issue at times. Bonds can either be held in the form of bond certificates or can also be held in demat form in your demat account. Interest on these taxable bonds is classified under the head of “Other Income” and taxed at your maximum rate. In case you make a capital gain by selling the bond in the open market, then the tax on capital gain will depend on the holding period. If you have held the bond for a period of less than 12 months, it will be treated as short-term capital gain and will be taxed at your peak rate of tax. If you sell the bond beyond a period of 12 months, it is classified as long term capital gain. In that case you either pay 10% of the capital gain as tax or 20% of the indexed capital gain as tax. (Indexed capital gain considers the impact of inflation over a period of time to give a fair assessment of the real returns made by the investor).

Tax-Free Bonds

Some government backed institutions and government companies are specifically authorized by the government to issue tax-free bonds. These bonds are normally meant for raising money for infrastructure purposes and this facility is seen as government support to the infrastructure sector. These tax-free bonds are normally issued by these institutions between January and March each year to coincide with the tax-planning season. Institutions like HUDCO, IRFC, IRCON, NHAI and IREDA are authorized by the government to issue tax-free bonds for financing long-term infrastructure projects.

Tax-free bonds typically come with a lock-in period of 5-10 years and pay lower rates of interest. Since the interest is entirely tax free, this product is heavily in demand from HNIs and wealthy businessmen who find these a smart way of investing their funds.

Let us understand how the yield calculations work in this case! For example, a tax-free bond may pay an interest rate of around 6.50%. But if you are in the peak tax bracket of 30.9%, then your effective yield works out to 9.41% (6.50 / (1-0.309). This makes these tax-free bonds substantially more attractive than bank FDs and even other bonds and debentures. But there is a catch. The lock-in period in these tax-free bonds is normally much longer and you must be prepared to give up your liquidity for that long. Also, these bonds are not very liquid in the secondary markets and there is a liquidity risk that you need to prepare for.

Another variant of the tax-free bond is the Capital Gains Bonds. Here, the person who has capital gains from the sale of an asset can get exemption from capital gains tax by investing the proceeds of the sale in these Capital Gains bonds. Here again, there is a lock in of a minimum of 3 years.