Tax-free bonds are fixed-income securities issued by public enterprises which offer investors tax-free income. One of the main benefits of tax-free bonds is that the tax is exempted per Section 10 of the Income Tax Act, 1961. In addition, tax-free bonds are typically issued with a maturity of a minimum of 10 years. Government entities like PFC, etc., issue tax-free bonds to raise funds to fund various projects, including housing and infrastructure. The interest rate for tax-free bonds is calculated based on factors such as the current Government Bond interest rate, the period of the bonds, and the credit rating, etc.
What is the Tax-Free Bond’s Function?
Tax-free bonds are issued and guaranteed by the government, so the chance of default on principal repayment and interest payment is meager. Therefore, investment in tax-free bonds is considered the safest choice for people who are not prone to risk and want to earn tax-free interest. In addition, the interest income earned from tax-free bonds isn’t subject to taxes.
For investors, tax-free bonds rank as one of the most appealing fixed-income bonds because they earn fixed interest without triggering any tax obligations. The principal amount is paid back at maturity, just like other bonds. When you invest in tax-free bonds, you are aware of the return you will have.
Benefits of tax-free bonds:
- Tax-free bonds: As the name implies, the interest earned on tax-free bonds is tax-free. In addition, the tax deducted by TDS is not applicable in the case of tax-free bonds.
- Long-Term Tenure: Tax-free bonds are perfect for those with a long investment horizon since their term spans 10-to-20 years or longer.
- Zero Risk of Default: The bonds with no tax are issued by public sector enterprises. Therefore, tax-free bonds are secure and have zero default risk, unlike other bonds. Investors also have the security of investing over the long term since the principal and interest repayment are guaranteed.
What are the disadvantages of Tax-Free Bonds?
Although they are listed on stock exchanges, tax-free bonds have extremely low liquidity. Take the scenario where you bought an ABC Tax-free bond in 2022. You’ll require the bond to be redeemed because of an emergency. Because of the maturity in 2026 right now, you cannot return the bond. Selling it to a bond investor via the stock exchange would be the only way to get out. But, it takes a lot of work to locate buyers and sellers for these bonds due to their low liquidity.
Collateral Bonds, sovereign gold bonds, and other kinds of bonds can be kept as security for loans. However, banks cannot recognise tax-free bonds as collateral for loans. Therefore, investors cannot make use of them as collateral for loans.
