Bonds and Debt Products
Bonds and Debentures are the main debt products that are available for the retail investor (apart from Debt Mutual Funds which are covered in the mutual fund section). They differ from other products in terms of the concept, transaction process as well as the taxation of the earnings. Within bonds and debentures there are different types of products that one can look to invest in i.e. Tax free and Taxable Bonds as well as Convertible Debentures and non-convertible debentures.
Before we explain each of these separately, we have to understand what these products conceptually are. Bonds and Debentures are investable products for the investor but on the other hand for the issuer of these products they are a representation of a loan. When an investor buys a debt product, in effect he/she is lending money to the issuer (company, state owned enterprise or a municipal corporation). That’s the basic concept. All Debt instruments have a few check points that must be looked into before an individual or corporate decides to make an investment into these. They are the following:
- Credit Rating: This is a third party assessment of the quality of the bond in terms of its credit performance. The renowned credit rating agencies in India are CRISL, Fitch and ICRA. A good credit rating is (AAA, AA+, AA , AA-). Investors should note that lower the ratings, higher will be interest paid on these instruments.
- Interest & Coupon Payment: Coupon is paid on Bonds. Debentures pay an interest. This is a critical factor that investors look at before making an investment into these products. Tax free bonds pay a coupon rate that is benchmarked against G-secs of the same maturity. Interest paid by Debentures usually have the level of income
- Tenure: Each product has a fixed tenure to maturity. Debentures are of shorter maturities as compared to Tax free Bonds. For instance, Tax Free bonds are usually issued with 10, 20 years till maturity. On the other hand, Debentures have shorter maturities for instance 3 years and 5 years.
- Payment Frequency: Investors should check when the interest and coupon payments will be made. Interest payments on Debentures could be made annually, semi-annually or quarterly. Usually in the case of Tax Free bonds coupon is paid out annually. Investors can also choose to reinvest the interest or coupon payment.
Let’ take a deeper look into each of these products:
Tax-Free Bonds: Bonds are fixed income products. Like other Bonds (taxable) they carry a coupon rate of interest and are issued for a fixed tenure. The tenure of these products is around 10, 15 to 20 years. The interest that is earned from these is tax free irrespective of the investors tax slab. The entities that issue these Bonds are central & state government bodies or undertakings. In India, entities that have issued the bonds are NHAI, PFC, HUDCO & IREDA to name a few. The investments made into these are secured, tax-free, redeemable and non-convertible.
Investments into tax free bonds can be done in two ways. They can either be subscribed to when the Bond issue opens for subscriptions or they can be bought from the secondary market (they can be traded in the secondary market in Demat mode only). As far as individuals go, retail individual investors (RIIs), high net worth individuals (HNIs) as well as non-resident individuals (NRIs) can invest in tax free bonds.
Let’s look at the taxation a little more closely. The interest that is earned is exempt from tax under section 10 (15) (iv) (h) of the Income Tax Act 1961. It must be clearly understood that only the interest earned through the coupon payments goes tax free. But if the investor chooses to sell his investment in the secondary market then Capital Gains Tax would be applicable on the sale under section 112.
In Debt Instruments the long term capital gains is computed at 20% after indexation and the period determining the long term status is 3 years. This means for investments held for a period less than 3 years, the investor is subject to taxes on the capital appreciation from the sale as per his/her income slab. An added benefit in the case of Bonds (both taxable and tax-free bonds) is that there isn’t any State Transaction Tax that is levied on such instruments.
Lastly, it is important to note that the investments in Tax free bonds are not exempted from taxation under section 80C of the Income Tax Act. The investors should always remember that tax saving and tax free investments are two very different concepts.
Taxable Bonds & Non Convertible Debentures:
Before we start, we would like to differentiate the Bonds from Debentures. Today Bonds and NCDs are used interchangeably but all that we would like to say to remove the confusion is that – All debentures are type of Bonds but not all bonds are debentures. Corporate Bonds for instance are used interchangeably as Corporate NCDs. But what’s important to the investor is not the Terminology but the rate of interest or coupon they will fetch, the time to maturity and the credit rating of these instruments. Just as a side note, convertible debentures are not issued commonly nowadays. Therefore we would limit the discussion to NCDs.
Taxable Bonds fetch a coupon rate of interest that is taxable whereas an investor in NCD or Non convertible debentures gets interest payments. Individuals and corporate bodies can invest in these products. There are two broad categories of Debentures:
- Secured NCD: Secured NCDs are those that offer an asset cover to the investor in case of a default. These are safer investments as compared to unsecured NCDs and generally offer interest payments that are below unsecured NCDs.
- Unsecured NCD: This only means that in the case of default the money invested in the company is not backed by the assets of the company. These NCDs clearly are a little riskier when compared to the secured NCDs and to compensate that offer a higher rate of interest to the Investor.
But the vital information for the investor is to still to look at the following points before investing into these products:
- Credit Rating: These products are usually rated by a third party that assesses the credit quality of the borrower. One can think of this as similar to the CIBIL score that individuals have on their loans. There are reputed agencies that rate these products such as CARE, ICRA, FITCH or CRISIL. These rating agencies indicate the risk involved in loaning money to the company (issuer of the NCD). The highest rating generally is a AAA rating followed by AA+, AA, AA-. A novice investor who wants a safe product for investments should definitely look at the rating of this product.
- Tax Treatment: The interest earned on these products is taxable and is sold on the secondary market the capital gains too will be taxable. So there are two components to this. Let’s look at the interest first. The interest earned is taxable according to the income tax slab of the investor. Secondly, the case of capital gains. If the Investor invests in an NCD and chooses to sell it in the secondary market to redeem his/her investment then in that case, he or she may is liable to pay tax on any capital gains that is made. Suppose after the sale of the NCD in the secondary market the investor gains INR 100 on each NCD, then in that case the tax treatment will be according to the duration to which the NCD was held. If the redemption was done before 3 years then the capital gains will be added to his income and treated according to the tax slab rates. On the other hand, if the redemption was made after 3 years then the amount gained will be taxed at 20% after indexation.
Documents required for investment in Bonds and Debentures:
In case the Investor has a Demat Account then he would only need to fill the Application Form in the case of Primary Issue of Bond/Debenture. But in case the Demat account isn’t opened he would require:
- PAN Card Copy (Self Attested)
- Address Proof
- Passport Size Photographs