What are tax free bonds? Is it a good bet?

Most of us have heard and read about tax free bonds but what exactly are tax free bonds? Tax free bonds are bonds whose interest returns are not taxable in the hand of the investors.

The income from these bonds are tax free and hence do not form part of the total income in computing income tax. These bonds are issued by quasi government owned institutions and are hence secured, unless the Indian government goes the Greece way and there is a sovereign debt crisis. As these bonds are traded on the NSE and BSE, they offer liquidity.

However, they may not be traded in large volumes like equities do. In a falling interest rates, regime tax free bonds are a positive bet.

In the budget 2012-13, the Finance Minister Pranab Mukherjee announced to double the amount companies can raise to Rs 60,000 crore in 2012-13 from 2011-2012 previously. The amounts include Rs 10,000 crore for NHAI, Rs 10,000 crore for IRFC, Rs 10,000 crore for IIFCL, Rs 5,000 crore for HUDCO, Rs 5,000 crore for National Housing Bank, Rs 5,000 crore for SIDBI, Rs 5,000 crore for ports and Rs 10,000 crore for power sector.

These bonds are a boon for those who are looking for long term investment and have plans to exit through secondary market. By investing in these bonds investors, last year got a tax-free coupon rate of 8.20-8.35% depending on the company they invested in.

For example, lets assume you invested in a HUDCO Tax free Bond in Feb 2012, with a coupon rate of 8.35% for a 15 year duration. The post tax returns are 8.35%. Now, let's assume at the same time the maximum one could get on a 5 year FD is 9%, pre tax. If you were in the 20 % tax bracket, your post tax yield would be 7.2%, while in the 30% tax bracket, your post tax yield would have been 6.3%. Therefore in the 20 and 30% tax bracket, the tax free bonds make better sense.

Always remember not to confuse tax savings bonds, with bonds that have tax benefits under sec 80CCF, as interest under these will be added to total income for the purpose of tax. Recently, Housing and urban development corporation HUDCO announced to raise about Rs 10,000 crore through tax-free bonds and other instruments this fiscal to fund business expansion.

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