How to save tax on bond investments

Bonds are fixed-income instruments issued by governments or corporations, offering predictable interest payments and principal repayment.

By Suresh Darak

Benjamin Franklin, a legendary inventor and statesman, once said, "Nothing is certain in life except death and taxes." While we can’t avoid the former, there are strategic ways to manage the latter, especially with fixed-income instruments.

The fixed-income landscape in India

Traditionally, Indians have parked their money in savings accounts or fixed deposits (FDs), which earn them no more than 8 percent. Moreover, the interest is taxed at the recipient's income tax slab rate, reducing their effective returns.

Debt mutual funds have also been a preferred choice until FY 2022, when these funds enjoyed favourable taxation with long-term gains receiving indexation benefits, effectively reducing the net tax to near-zero. However, Budget 2023 removed this benefit, and now debt mutual funds are taxed at slab rates, similar to FDs. Since then, debt funds have lost their appeal.

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In this evolving landscape, bonds have emerged as a robust alternative for tax-efficient fixed income portfolios. Here's how laddering a bond portfolio can optimise returns while minimising taxes.

Understanding bonds

Bonds are fixed-income instruments issued by governments or corporations, offering predictable interest payments and principal repayment. Held in demat form, they are liquid and tradeable on exchanges like NSE and BSE. While the bond market in India is valued at Rs 250 lakh crore, it has historically been dominated by institutional investors, but is now accessible to retail investors. Now, bonds are available to retail customers through SEBI-registered online bond platforms like Bondbazaar, where users can easily buy and sell all types of bonds. Here are the various strategies investors can explore to save taxes through bonds-

Strategies for tax-efficient bond investments

1. Investment grade bonds: Bonds provide fixed returns with interest (coupon) taxed at slab rates. For instance, investment-grade bonds offering a 12 percent coupon yield around 8.5-9 percent post-tax, assuming a 20-30 percent tax bracket.

2. Secondary market bonds: Buying bonds on secondary markets can offer additional benefits. For example, a bond with a 12 percent coupon issued at a face value of Rs 1,000 may trade at Rs 950. An investor purchasing it at Rs 950 earns Rs 120 annually (taxed at slab rate) and Rs 50 as long-term capital gains (LTCG) on maturity, taxed at just 12.5 percent after one year. This strategy reduces the overall tax burden. Zero-coupon bonds, where gains come entirely from capital appreciation, can also be considered for further tax efficiency.

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3. Section 54EC bonds: Investors with long-term capital gains from property sales can reinvest proceeds in specific bonds (e.g., REC, NHAI) under Section 54EC to claim a 100 percent tax exemption. These bonds have a 5-year lock-in and offer about 5.25 percent returns, with a maximum investment limit of Rs 50 lakh.

4. Deferred coupon bonds: Bonds with interest paid only at maturity are ideal for investors nearing retirement. Tax on interest is deferred until receipt. For instance, a 58-year-old retiring at 60 can invest in a bond maturing in three years with interest paid at the end. Post-retirement, the investor's tax slab may drop, reducing the tax outgo on maturity.

5. Deep discount bonds: Government deep discount bonds, purchased at a discount (e.g., Rs 70 for a bond maturing at Rs 100), generate gains taxed only at maturity. These bonds suit pre-retirement investors in higher tax brackets, as post-retirement, lower tax rates apply.

They also serve as margin money for F&O trading, so instead of giving cash, traders can keep these bonds as margin money and earn higher interest. Also, if there is a loss in futures and options trading, it can be offset against interest income from bonds, making interest income completely tax-free.

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6. Tax-free bonds: Tax-free bonds issued by PSUs like PFC, REC, NHAI, and HUDCO offer interest entirely exempt from tax. These bonds, guaranteed by the Government of India, yield 5.25-5.75 percent. For investors in the 30-40 percent tax bracket, this translates to an effective pre-tax yield of 8.5-9.5 percent. Highly liquid, these bonds can be traded anytime on exchanges, combining safety, returns, and liquidity unmatched by other fixed-income products.

Conclusion

With a variety of options available, investors can build a bond portfolio tailored to their tax and income requirements. Bonds not only provide predictable returns but also offer flexibility and tax advantages that outshine traditional fixed-income instruments. By strategically leveraging bonds, investors can achieve higher post-tax returns and a more efficient fixed-income portfolio.

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any decisions.