Mutual funds are more tax efficient over a holding period of three years, by virtue of indexation.
The salient aspect of taxation of bonds is that the coupon or interest on bonds / debentures is taxable as ‘other income’, which is taxable at your marginal slab rate. For most investors, the marginal slab rate is 30% plus surcharge and cess. Only a few investors would be at a lower tax bracket; for instance, senior citizens. In other words, there is no way to optimise the coupon / interest on bonds from a taxation perspective.
The capital gains tax component is taxable at a relatively lower rate, provided you hold it for the requisite period. For listed bonds, the holding period required for taxation as long-term capital gains is one year. If you hold a listed bond for less than one year, it is taxable at your marginal slab rate. The good part is, for a holding period of more than one year, the rate is 10% plus surcharge and cess. However, from a broad perspective, this per se does not lead to much tax efficiency. The reason is, most of the returns from bonds come from the coupon / interest and only a small component comes from capital gains, that too if you sell before maturity at a profit compared to your purchase price.
You purchase a bond in the primary market at the face value of Rs 100, and the bond is listed. The bond carries a coupon of 7%. You hold it for three years and sell it for Rs 102. In this case, your total return over three years is Rs 7 per year of coupon = Rs 21 plus Rs 2 of capital gains = Rs 23. Of this, Rs 21 is from coupon which is taxable at your marginal slab rate. Only Rs 2 is capital gains taxable at 10%. If you hold it till maturity, or if the sale price is less than Rs 100, there won’t be any capital gain and the entire earning would be from coupon only.
For clarity, in zero-coupon bonds, the difference between issue price and maturity price is taxable at your marginal slab rate. Though technically there is no coupon as such in a zero-coupon bond, conceptually, it is comparable to coupon, and taxable at the same rate. The only exception to this is certain notified zero-coupon bonds, which are taxable as capital gains, notified under Section 2(48) of Income Tax Act.
In Section 54EC capital gains tax savings bonds, while you save up to Rs 50 lakh of capital gains tax per financial year, the coupon on these bonds is taxable at your slab rate.
Indexation for computation of long-term capital gains tax is available in debt mutual funds over a holding period of three years or more. This generates significant tax efficiency. However, this is available only in mutual funds, not in direct holding of bonds. The non-availability of indexation for taxation in bonds limits the avenues for generating tax efficiency.
There are tax-free bonds issued by certain public sector undertakings (PSUs). There have been no fresh issuances over the last six years, but the existing stock is available through the secondary market. The coupon on these is tax-free; in case of any capital gain, that component would be taxable. These are rated AAA, hence prime credit quality. The yield (annualized interest rate) available in the secondary market in tax-free PSU bonds would be consequently lower, as the market factors in the tax efficiency while dealing in these.
The way to look at these is the comparable pre-tax equivalent yield level. As an example, if you are getting a tax-free PSU bond at a yield of say 5.25% and your tax rate is 31.2% including cess, then the comparable level is 5.25% / (1-31.2%) = 5.25% / 0.688 = 7.63%. The assumption here is, if you invest in an usual taxable bond, you have to pay tax at 31.2%, hence the matching level of yield is 7.63% to get 5.25% net of tax. You have to check whether you are getting that level of return in similar quality AAA rated taxable PSU bonds from the secondary market.
Mutual funds are more tax efficient over a holding period of three years, by virtue of indexation. Direct bonds are tax-efficient for people in relatively lower tax bracket.