Municipal bonds (sometimes referred to as “munis”) are fixed-income investments that offer better after-tax returns than comparable taxable corporate or government issues. Interest paid on municipal bonds is generally excluded from federal taxes and, in some cases, state and local taxes as well.
Is it wise to invest in tax-free bonds?
Municipal bonds are an excellent method to keep your money safe while earning interest. The majority of them are tax-free at the federal level, and several are also tax-free at the state and local levels. Munis are frequently treated as a unique asset class, therefore understanding the fundamentals of muni bonds is essential.
Are tax-exempt bonds truly tax-exempt?
The fact that municipal bonds are tax-free in the United States is a major selling feature. That is, interest payments are not subject to federal taxation.
What is the interest rate on tax-free bonds?
You can invest in either ordinary corporate bonds or tax-exempt municipal bonds. Corporate bonds have a yield of 7%, while tax-free municipal bonds have a yield of 5%.
What are tax-free municipal bond funds and how do they work?
What are the most common uses for bonds? A bond is a type of debt that is used to fund day-to-day operations or special projects. It could be a short-term bond with a duration of less than three years or a long-term bond with a tenure of 20 or 30 years.
Municipal bonds are issued by the government of a state, a city, or a municipality. Because these government bodies are not subject to federal taxation, money earned from municipal bond investments is also tax-free. State and local taxes are normally exempt from municipal bonds, especially in the state where the bond is issued, but this is not always the case. As a result, before investing in a municipal bond, make sure it is free of any nonfederal income taxes. Profits earned from the sale of municipal bonds may be taxed. As a result, the income can be subject to a tax known as capital gains.
Municipal bonds are the only investments made by tax-free mutual funds. When bonds are issued, these funds employ the combined funds of their investors to acquire them. These bonds then pay interest on the principle at regular intervals and refund the entire principal at a certain maturity date. Mutual funds are constantly replacing older bonds that have matured and paying them off with new bond issues.
You are not investing in an individual bond when you invest in a tax-free mutual fund. You are purchasing shares in the mutual fund’s total investments and investing in all of the mutual fund’s bonds.
Is now the right moment to invest in a tax-advantaged mutual fund? However, the average investor should be cautious because there are some possible hazards in store. Find out if tax-free mutual funds are correct for you by reading on.
What is the average yield on tax-exempt municipal bonds?
The top five municipal bond funds are ranked by their one-year trailing total return (TTM) as of the market close on December 10, 2021. The funds were chosen from a collection of funds that are open to new investors, need a $1,000 minimum initial investment, and have at least $50 million in assets under management (AUM). The first four funds are all Morningstar-rated “Over the last year, the “High Yield Muni” category has averaged a total return of 6.0 percent. The last fund is owned by the “Muni National Intermediate” with a total return of 1.9 percent throughout the same time period.
How do I go about purchasing tax-free bonds?
The interest income from tax-free bonds is completely tax-free. Furthermore, these bonds are exempt from TDS (tax deducted at source). However, because the principle amount invested in tax-free bonds does not qualify for a tax deduction under Section 80C, it is advisable to record your interest income.
Tax-free bonds are available in both physical and electronic form. When compared to bank FDs, tax-free bonds provide a more tax-efficient return for investors in the higher tax bands.
Because these programs are issued on behalf of the government, the chances of default on principal and interest payments are quite minimal. It also provides financial protection as well as a predictable monthly or annual income. As a result, it is relatively risk-free.
Tax-free bonds cannot be liquidated as quickly as debt mutual funds, for example. Liquidation of tax-free bonds may be difficult due to the fact that government bonds are long-term assets with longer lock-in periods.
The lock-in period for tax-free bonds is longer, ranging from 10 to 20 years. You are unable to withdraw your funds before to the maturity date. As a result, please ensure that you will not want this money soon after investing.
Tax-free bonds can be purchased online or in person using a Demat account. To meet short-term financial goals, you can purchase tax-free bonds on the secondary market.
The return on these bonds is mostly determined by the purchase price. This is due to the fact that they are traded in little quantities with a small number of buyers and sellers.
When considering the tax exemption on interest, the rate of interest offered on tax-free bonds often varies from 5.50 percent to 6.50 percent, which is quite appealing.
The interest is paid to the bondholder once a year. The rates, however, are subject to change because they are linked to the current rate of government securities. If you invest in tax-free bonds at current yields, you may obtain a 6% tax-free return.
Is it wise to invest in I bonds?
- I bonds are a smart cash investment since they are guaranteed and provide inflation-adjusted interest that is tax-deferred. After a year, they are also liquid.
- You can purchase up to $15,000 in I bonds per calendar year, in both electronic and paper form.
- I bonds earn interest and can be cashed in during retirement to ensure that you have secure, guaranteed investments.
- The term “interest” refers to a mix of a fixed rate and the rate of inflation. The interest rate for I bonds purchased between November 2021 and April 2022 was 7.12 percent.
What kinds of tax-free bonds are available?
Are you a senior citizen, a high-net-worth individual, or someone who pays the highest tax rate and wants to invest in debt securities? If you answered yes, you should look into tax-free bonds. If you want to invest for a period of 10 years or more, HUDCO (NE series), PFC (N8 series), or IIFCL bonds are good options (N4 series). The remaining term on these bonds is 12-13 years.
If you want to invest for a shorter period of time, try REC (NI series), IREDA (N7 series), NABARD (N2 series), or HUDCO (NI series) bonds (ND series). The remaining term on these bonds is 6-10 years.
Here are a few of the best-performing Tax Free Bonds to consider. HOUSING & URBAN DEVELOPMENT CORPORATION LIMITED offers a 9.01 coupon rate, MAHINDRA & MAHINDRA FINANCIAL SERVICES LIMITED offers a 9, POWER FINANCE CORPORATION LIMITED offers an 8.92 coupon rate, INDIA INFRASTRUCTURE FINANCE COMPANY LIMITED offers an 8.91 coupon rate, and so on.
1) What are tax-free bonds, and how do they work?
Bonds that are tax-free are debt instruments that are typically issued by public sector entities (PSUs). A public sector undertaking collects funds from investors for a set period of time in exchange for issuing a tax-free bond and promising to refund the funds at the conclusion of the bond’s term. It also pledges to pay a fixed annual interest rate for the duration of the bond. On the maturity date, the corporation redeems the bond and credits the maturity proceeds to the investor’s bank account.
2) What distinguishes tax-free bonds?
- Issued at face value: These bonds are normally issued with a Rs 1000 face value. To put it another way, one unit of the tax-free bond costs Rs 1000 at the moment of issuance.
- There is a coupon rate on the bonds. Power Finance Corporation (PFC), for example, issued the N6 series of bonds at an annual interest rate of 8.43 percent. It means that bondholders will receive an annual interest rate of 8.43 percent. Interest is paid either semi-annually or annually, depending on the bond’s issuance date.
- Bonds are issued for periods of more than 5 years and can last up to 2030 years. They can be held till maturity by an investor. These bonds can be traded on stock exchanges such as the NSE and BSE. If an investor needs money before the bonds mature, they can sell them on the stock exchange.
3) What is the tax-free status of interest earned on tax-free bonds?
The fact that the interest generated on tax-free bonds is tax-free is the most tempting feature to investors. Section 10 of the Income Tax Act makes this possible. Because the interest paid to investors is tax-free, persons in the highest tax bracket who want to invest in debt securities prefer to buy these bonds.
4) What are the dangers of tax-free bonds?
Tax-free bonds are typically issued by PSUs with the union government as the primary stakeholder. As a result, the chance of default is quite minimal. However, liquidity can be an issue. In the case of several of these bonds, trade volumes are minimal. If you want to sell them on the exchange, you can have a hard time finding a buyer. Even if you find a buyer, you may not be able to get the price you want.
5) How do you go about purchasing tax-free bonds?
There are two ways to purchase tax-free bonds. You can either apply for the bonds when the firm issues a new bond issue, or you can acquire bonds that have already been issued and are listed on the stock exchange from another bondholder who wants to sell.
You can apply for a bond in either physical or demat format when applying for a new issue. However, you’ll need a trading and demat account to buy and sell bonds on the secondary market. You must place a buy order from your trading account in order to purchase the bonds. The bonds will be credited to your demat account at the moment of clearing and settlement. Similarly, you must submit a sell order from your trading account to sell the bonds. The exchange will debit the bonds from your demat account at the moment of clearing and settlement.
If you hold the bonds until they mature, the issuing business will redeem them and credit the redemption value to your bank account.
6) What are the tax implications of tax-exempt bonds?
For tax purposes, you must understand the following phases of a bond as an investor:
- At the time of issuance: Some financial instruments are eligible for a tax deduction at the time of purchase or issuance. Please keep in mind that tax-free bonds do not qualify for any tax benefits at the time of purchase or issuance.
- Annual interest earned on the bond: Under Section 10 of the Income Tax Act, annual interest earned on tax-free bonds is tax-free. As a result, any interest you earn on these bonds is tax-free in your hands as an investor. The interest earned on these bonds is not subject to tax deducted at source (TDS).
- Capital gains: Depending on the price at which you acquired and sold the tax-free bond, you will either have a capital gain or a capital loss if you sell it before it matures. The capital gain will also be classed as either a short-term or long-term capital gain, depending on the bond’s holding period. If you generate capital gains from a tax-free bond, they are taxable, whether they are short-term or long-term.
- Maturity proceeds: If you hold the bond until it matures, the corporation will redeem it at face value (the price at which you bought the bond from the company). As a result, there will be no capital gain when the bond is redeemed at maturity. There will be no capital gain tax since there will be no capital gain.
7) Who should buy tax-exempt bonds?
Tax-free bonds are a good option for investors looking for debt instruments with tax-free interest income. Tax-free bonds are an option for senior citizens, high net worth individuals (HNIs), and others in the highest income tax bracket. These bonds typically have a long term of more than five years, ensuring a steady, tax-free income for a long time.
Tax-free bonds are more tax-efficient than bank fixed deposits from the standpoint of taxes. The interest on a bank fixed deposit is taxable, but the interest on tax-free bonds is not.
8) What corporations are known for issuing tax-free bonds?
9) What considerations should an investor make while purchasing bonds on the secondary market?
The face value of the bonds issued by the corporation differs from the price at which they are exchanged in the secondary market. The market price of a bond is determined by the change of market interest rates after the bond has been issued.
Interest rates and bond prices are inversely related. As a result, if market interest rates rise, bond prices will fall. Bond prices will climb if market interest rates fall. No new tax-free bonds were issued by any company in the current year (2021) or the previous year (2020). In addition, following the economic impact of COVID-19, the RBI has decreased interest rates in FY 2020-21. As interest rates fall, the market prices of all bonds issued prior to 2020 have risen.
All tax-free bonds with a face value of Rs 1000 issued before 2020 are selling at a market price ranging from Rs 1085 to Rs 1500 as of July 2021. The market price is determined by criteria such as when the bond was issued, the coupon rate at which it was issued, the remaining time to maturity, the seller’s price forecast, and so on. So, when purchasing tax-free bonds on the secondary market, bear the following considerations in mind.
When you buy tax-free bonds on the secondary market, you will be paid annual interest based on the coupon rate. Your real return, however, will be determined by the market price at which you purchased the bond.
For example, REC Limited issued a Rs 1000 tax-free bond (NH series) with a coupon rate of 7.43 percent per annum. Assume you purchased the bond at a market price of Rs 1325 in July 2021. The corporation would pay you Rs 74.3 in annual interest (7.43 percent p.a. on the face value of Rs 1000). However, you must consider a return of Rs 74.3 on a Rs 1325 investment when computing your actual yearly return (bond market price). As a result, your annual return will be 5.61 percent.
10) The majority of tax-free bonds are now selling at a discount to their face value. Will this be the case in the future as well?
The RBI slashed interest rates to multi-year lows in FY 2020-21 to aid the Indian economy’s recovery from the COVID-19-induced recession. Most bonds’ prices have risen as a result of the interest rate drop, and they now trade at a premium to their face value.
Interest rates appear to have reached a nadir in July 2021. Since the last few months, the RBI has kept interest rates unchanged. The RBI is expected to normalize liquidity in the future before gradually raising interest rates. Bond prices are predicted to fall as interest rates rise due to their inverse relationship with interest rates.
The bond’s market price will fall below the face value of Rs 1000 once market interest rates exceed the coupon rate at which it was issued. The bond is considered to be selling at a discount to the face value when the market price falls below the face value.
Opportunity cost
Municipal bonds’ tax advantages aren’t as valuable if you’re in a lower tax band as they are if you’re in a higher tax bracket.
If that’s the case, you could be better off putting your money into alternative investments for a larger return.
They may not be liquid
If you need money quickly, you should be aware that municipal bonds may have liquidity problems.
You might not be able to find an active market for your bonds, which means you won’t be able to sell them when you want at the price you want.