What is a Bond?

Bond is a debt instrument which provides finance to large companies, financial institutions and government in the form of loan. It differs from a typical debenture as:

  • The Bonds are secured and do not contain any risk in relation to repayment of principal amount and any outstanding interest.
  • Convertible Debentures may form part of share capital but Bonds are pure loans and do not affect capital structure.

As stated above, Bond is a risk-less debt security which is generally issued by very large corporations, Financial Institutions and Government to finance big projects. Some of the main features of a Bond are as follows:

  • Lower rates: Keeping in view the risk-return tradeoffs, lower risk means lower returns. Therefore, bonds generally pay a low interest on principal amount invested by investor which is also called coupon rate.
  • Long Maturity Life: They generally have a long maturity period ranging from 10 to 20 years.
  • Listed: Tax-free bonds are generally listed on the Bombay and/or National Stock Exchange to provide exit route to investors.
  • Trading: These bonds are available for buying within a specific period during the issue period. After that one can buy from the stock exchange on which they are listed.
  • Capital Gains: If the Bond is sold in secondary market (stock exchange), any capital gain from sale is taxable. As they belong to debt category, indexation benefit is available. If sold within one year one has to pay Short term Capital Gain at the normal rate, while long-term capital gains are usually taxed at 10% without indexation and 20% with indexation. However as per third proviso to Section 48 of Income Tax Act, 1961, benefits of indexation of cost of acquisition under second proviso of Section 48 of Income tax Act, 1961 is not available in case of bonds and debenture, except capital indexed bonds. Thus, long term capital gain tax can be considered as 10% on listed bonds (without indexation).
  • Wealth-tax: It is not leviable on investment in bond under section 2(ea) of the Wealth-tax Act, 1957.

Tax-free Bonds

All notified bonds issued by Government/local authority etc. are considered as tax-free bonds. Under section 10(15)(i)/(iic)/ (iid)/ (iv)(h), interest from such bonds is exempt wholly from tax. However, for FIIs and QFIs, there shall be a lower rate of 5% on interest on rupee denominated bonds issued by Indian Company/ Government under section 115A(1)(a)(iiab) which will be deducted by issuer of bonds under section 194LD.

The recent notification in this regard dated 08-08-2013 notifies bond of following entities to be tax free:

  • Cochin Ship Yard Limited(CSL)
  • Ennore Port Limited (EPL)
  • Airport Authority of India Limited(AAI)
  • Indian Infrastructure Finance Company Limited (IIFCL)
  • Indian Renewable Energy Development Agency Limited (IREDA)
  • Housing and Urban Development Corporation Limited (HUDCO)
  • Rural Electrification Corporation Limited(REC)
  • National Housing Bank (NHB)
  • Power Finance Corporation Limited (PFC)
  • Indian Railway Finance Corporation Limited (IRFC)
  • National Highways Authority of India (NHAI)
  • NHPC Limited (formerly known as National Hydroelectric Power Corporation Ltd.)
  • NTPC Limited (formerly known as National Thermal Power Corporation)

These entities are authorized to issue bonds during the financial year 2013-14 which shall be tax-free, secured, redeemable, non-convertible bonds, aggregating to specified amounts. The tenure of the bonds is ten, fifteen or twenty years

For example NHAI issued bonds of Rs.1,000 each @ 8.27%-8.52% for 10 years bonds and @8.50%-8.75% for 15 years bond to be redeemed at par

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. The precedence of earning from a tax free bond over Fixed Deposit can be explained with following example:

Let the interest rate of FD be 9% and on tax-free bonds be 7.5% (currently the rate varies from 7.69%-7.88%). The amount to be invested be Rs.10,000

Interest on FD

10,000*0.09 =                           900

Less: Tax @ 30%= (270)

Net Gain: =                               630

Interest on tax-free bonds

10,000*0.075=                              750

Therefore, it is clear that post-tax returns from tax-free bonds are greater than Fixed Deposit Interest.

ffect of Inflation on Tax free Bonds:

Hitherto, we calculated returns only after taking into account taxation factor, however, there is a more prominent factor i.e. Inflation which makes an important consideration in investment decision as it is pervasive. Therefore, in the above example taking into account the effect of inflation ( assuming 7%), we infer as follows:

Decrease in value of money invested

10,000*0.07=                           (700)

Add: Net interest income        630

Net Gain/(Loss)=                      (70)

Decrease in value of money invested

10,000*0.07=                           (700)

Add: Net interest income        750

Net Gain/(Loss)=                        50

Therefore, it is evident from above that Real Rate of Return on FD is a negative -0.7% while on Tax-free Bonds it is a positive 0.5%.

However, if a person’s income fall below the minimum exemption limit or is in the tax slab of 10% then investing in FD may be more beneficial.

Bond pricing:

Investment in Tax-free Bonds should not be limited to gaining tax benefits. It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received and help to know- should the bond be purchased?

Price of a Bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity.

The general definition of yield is the return an investor will receive by holding a bond to maturity. Required yield, on the other hand, is the yield or return a bond must offer in order for it to be worthwhile for the investor. So if you want to know what your bond investment will earn, you should know how to calculate yield.

Bond-yield measures:

1. Single Period Rate of Return: This is the return earned by a bondholder by holding a bond for a year. This can be calculated as:

ROR= I+ (P1-P0)/ P0

I is the interest paid
P1 is price at end of the holding period
P0 is price at the beginning of the period

2. Current yield: When a bond is purchased at the prevailing market price and the interest is received, then the rate of return earned on that bond will be called current yield. So,
                                 Current yield = Interest rate/market price

3. Yield to Maturity (YTM): This is the rate of return a bondholder earns, if he holds the bond purchased till maturity. In other words, YTM is the rate of return, which equates the future cash flow of the bond to its purchased price.
                                                                P= I *[ { (1+r) -1} / {r(1+r)t } ] + MV/ (1+r) t

Where, P = price of a bond
I=annual interest payable on bond
MV=principal amount on the bond payable at maturity
t = maturity period of bond
r= YTM

If interest is not paid annually then take no. of payments in a year be “n” and

I will become I/n

r will become r/n

t will become t*n

Relationship between Bond price and Bond yield:

Generally, there is an inverse relationship between both, i.e.:

  • If YTM= Coupon rate then Bond Price= Par Value
  • If YTM> Coupon rate then Bond Price< Par Value
  • If YTM< Coupon rate then Bond Price> Par Value

Let the par value of a Bond be Rs. 100 and Coupon rate be 8% with a maturity of 10 years

Case1: If YTM is 8% Bond Price= 8 *[ { (1+0.08)10 -1 } / { 0.08(1+0.08)10 } ]       +  100/(1+0.08) 10

Rs. 100

Case2: If YTM is 7% Bond Price= 8 * [ { (1+0.07)10 -1 } / { 0.07(1+0.07)10 } ]    +  100/(1+0.07) 10

Rs. 107.03

Case3: If YTM is 9% Bond Price= 8 * [ { (1+0.09)10 -1 } / { 0.09(1+0.09)10 } ]     +  100/(1+0.09) 10

Rs. 92.78

This is because, when issuer offers bond at the coupon rate which is less than required yield (or less than interest he can get from other securities in the market) then he must offer them at discount to make it attractive to investors and vice versa.

Buying Bonds from Secondary Market:

One does not need to wait for new issue and can buy existing bonds traded on stock exchanges through secondary market. Currently, it is said that one can buy bonds at a good bargain. At times Bonds have Step down feature which means that when you buy them from the secondary market, you get a slightly lower rate of interest than the primary subscriber.

For example, if a bond having maturity of 10 years has par value Rs. 1,000 and coupon rate is 8.2% then the primary subscriber will get an annual coupon payment of Rs. 82. This is a fixed payment. If a person wants to buy 10 such bonds and YTM is 7.4%, then selling price will Rs.10551.68. Therefore, a person shall have to pay Rs.551.68 extra and will receive same coupon payment of Rs.820, thereby earning @7.77% instead of 8.2%

54EC (Capital Gain) Bonds

Section 54EC prescribes that any Long term Capital Gains shall be exempt if its proceeds are invested in Long-term specified assets. Capital Bonds of NHAI and RECL are such Long-term specified assets. Therefore, investing in such bonds may help you reduce tax burden. Further, this section contains following conditions:

  • Investment in any FY should not exceed Rs. 50 lakhs (For period 2007-15)
  • Investment in year of transfer of original asset and in subsequent year does not exceed Rs. 50 lakhs (w.e.f. 1-4-2015)
  • A lock-in-period of 3 years is necessary to claim such exemption.
  • Taking loan on security of such specified assets shall be deemed to be the conversion of bonds into money

However, a person claiming exemption under this section shall not be eligible to claim exemption under section 80C.

Bonds under section 80C

Section 80C lists down the instruments, which Individuals and HUFs can invest in order to save tax. You can invest a maximum of Rs 1.5 lakh in all these instruments put together. Deductions in respect of Bonds are outlined below:

  • Infrastructure Bonds:

These are also popularly called Infra Bonds. These are issued by infrastructure companies, and not the government. The amount that you invest in these bonds can also be included in Sec 80C deductions.

  • NABARD rural bonds:

There are two types of Bonds issued by NABARD (National Bank for Agriculture and Rural Development): NABARD Rural Bonds and Bhavishya Nirman Bonds (BNB). Out of these two, only NABARD Rural Bonds qualify under section 80C.