Bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (ex semi annual, annual, sometimes monthly).

Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.

Tax free bonds have emerged as a popular investment option due to the taxation benefits they offer. The interest income on these bonds, generally issued by government enterprises, is exempted from taxation.

The salient features of the tax-free bonds:

  • What are tax-free bonds: These bonds are mostly issued by government enterprises and pay a fixed coupon rate (interest rate). As the proceeds from the bonds are invested in infrastructure projects, they have a long-term maturity of typically 10, 15 or 20 years.
  • Tax benefits: The income by way of interest on tax-free bonds is fully exempted from income tax. The interest earned from these bonds does not form part of your total income. There is no deduction of tax at source (TDS) from the interest, which accrues to the bondholders. But remember that no tax deduction will be available for the invested amount.
  • Interest rate: The coupon (interest) rates of tax-free bonds are linked to the prevailing rates of government securities. So these bonds become attractive when the interest rates in the financial system are high.
  • Interest payment: The interest on these bonds is paid annually and credited directly in the bank account of the investor.
  • Tax free bonds vs bank fixed deposits (FDs): The interest earned on bank FDs and other normal bonds are added to the income of the investor and taxed as per the income-tax slabs. As interest earned from tax-free bonds are not taxed, investors in higher tax brackets mostly earn a better post-tax return than from FDs. But remember, the bank FDs score over tax-free bonds in terms of liquidity as these bonds have a longer maturity tenure.

The Bonds may be held by –

  • An individual, not being a Non-Resident Indian (NRI)
  • In his or her individual capacity, or
  • In an individual capacity on joint basis, or
  • In an individual capacity on anyone or survivor basis, or
  • On behalf of a minor as father/mother/legal guardian