Bonds are debt instruments issued by organizations and governments to borrow money. Bondholders are lenders who receive interest payments until the bond matures, at which point the principal is returned. The main types of bonds are zero-coupon bonds, floating rate bonds, callable bonds, puttable bonds, convertible bonds, and amortizing bonds. People invest in bonds to earn interest income and save on taxes. The tax treatment of bond returns depends on the type of bond and whether the investor realizes capital gains or losses upon selling.

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What are bonds?
In simple words, Bonds refer to debt instruments bearing interest on maturity. In
simple terms, organizations may borrow funds by issuing debt securities named
bonds, having a fixed maturity period (more than one year) and pay a specified rate
of interest (coupon rate) on the principal amount to the holders. Bonds have a
maturity period of more than one year which differentiates it from other debt
securities like commercial papers, treasury bills and other money market
instruments.
Bonds and stocks are both securities, but the major difference between the two is
that (capital) stockholders have an equity stake in the company (i.e., they are
owners), whereas bondholders have a creditor stake in the company (i.e., they are
lenders). Another difference is that bonds usually have a defined term, or maturity,

2. after which the bond is redeemed, whereas stocks may be outstanding indefinitely.
An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).
Types of Bonds and Return from it:
Zero Coupon Bonds
Zero CouponBonds are issued at a discount to their face value and at the time of
maturity, the principal/face value is repaid to the holders. No interest (coupon)is
paid to the holders and hence, there are no cash inflows in zero couponbonds. The
difference between issue price (discounted price) and redeemable price (face value)
itself acts as interest to holders. The issue price of Zero CouponBonds is inversely
related to their maturity period, i.e. longer the maturity period lesser would be the
issue price and vice-versa. These types of bonds are also known as Deep Discount
Bonds.
Floating Rate Bonds
In some bonds, fixed couponrate to be provided to the holders is not specified.
Instead, the couponrate keeps fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.
Callable Bonds
The issuer of a callable bond has the right (but not the obligation) to change the
tenor of a bond (call option). The issuer may redeem a bond fully or partly before
the actual maturity date. These options are present in the bond from the time of
original bond issue and are known as embedded options. A call option is either a
European option or an American option. Under an European option, the issuer can
exercise the call option on a bond only on the specified date, whereas under an

3. American option, option can be exercised anytime before the specified date.
This embedded option helps issuer to reduce the costs when interest rates are
falling, and when the interest rates are rising it is helpful for the holders.
Puttable Bonds
The holder of a puttable bond has the right (but not an obligation) to seek
redemption (sell) from the issuer at any time before the maturity date. The holder
may exercise put option in part or in full. In riding interest rate scenario, the bond
holder may sell a bond with low couponrate and switch over to a bond that offers
higher couponrate. Consequently, the issuer will have to resell these bonds at
lower prices to investors. Therefore, an increase in the interest rates poses
additional risk to the issuer of bonds with put option (which are redeemed at par)
as he will have to lower the re-issue price of the bond to attract investors.
Convertible Bonds
The holder of a convertible bond has the option to convert the bond into equity (in
the same value as of the bond) of the issuing firm (borrowing firm) on pre-
specified terms. This results in an automatic redemption of the bond before the
maturity date. The conversion ratio (number of equity of shares in lieu of a
convertible bond) and the conversion price (determined at the time of conversion)
are pre-specified at the time of bonds issue. Convertible bonds may be fully or
partly convertible. For the part of the convertible bond which is redeemed, the
investor receives equity shares and the non-converted part remains as a bond.

4. Amortising Bonds
Amortising Bonds are those types of bonds in which the borrower (issuer) repays
the principal along with the couponover the life of the bond. The amortising
schedule (repayment of principal) is prepared in sucha manner that whole of the
principle is repaid by the maturity date of the bond and the last payment is done on
the maturity date. Forexample - auto loans, home loans, consumer loans, etc.
Bonds with Sinking Fund Provisions
Bonds with Sinking Fund Provisions have a provision as per which the issuer is
required to retire some amount of outstanding bonds every year. The issuer has
following options for doing so:
 By buying from the market
 By creating a separate fund which calls the bonds on behalf of the issuer
Since the outstanding bonds in the market are continuously retired by the issuer
every year by creating a separate fund (more commonly used option), these types
of bonds are named as bonds with sinking fund provisions.
Why to invest in bond?
Many people invest in bonds with an objective of earning certain amount of
interest on their deposits and/or to save tax. Bonds are considered to be a less risky
investment option and are generally preferred by risk-averse investors. Though
investors should not get overtly confident of investing in bonds as bond prices are
also subject to market risk. For example, bond prices have a negative correlation
with interest rates due to which any increase in interest rates can lead to a fall in

5. bond prices and vice-versa. Thus, it is recommended that investors should consider
the risk-return factor (i.e. the expected return for the given level of risk) before
investing.
Tax implication on return from Bond investment:
Government Bonds
Taxation of Zero Coupon Bonds:
Despite the fact that they have no stated coupon rate, zero-coupon investors must
report a prorated portion of interest each year as income, even though it has not
been paid out. Zeros are issued at a discount and mature at par, and the amount of
the spread is divided equally among the number of years to maturity and taxed as
interest, just as any other original issue discount bond.

6. The primary advantages attracting an investor to Treasury bills or money market
mutual funds are their liquidity and safety. But there is another significant benefit
offered by particular money market instruments known as "munis," or short-term
municipal securities: federal tax savings, which are particularly beneficial to those
who fall within a high federal tax bracket.
Savings Bonds
Series E and EE savings bonds are also state and local tax free, except that the
interest on them may be deferred until maturity. Series H and HH bonds pay
taxable interest semiannually until maturity. Series I bonds also pay taxable
interest, which may be deferred like Series E/EE bonds. The interest from Series E
and I bonds may also be excluded from income if the proceeds are used to pay
higher education expenses.
Municipal bonds
Municipal bonds are generally appropriate for high-income investors who are
seeking to reduce their taxable investment incomes. The interest from these bonds
is tax free at the federal, state and local levels as long as the investor resides in the
same state or municipality as the issuer. However, if you buy municipal bonds in
the secondary market and then sell them later at a gain, that gain will be taxable at
ordinary long- or short-term capital gain rates. Municipal bonds pay a
commensurately lower rate than other bonds as a result of their tax-free status. If
you want to accurately compare the return you will receive from a municipal bond
versus a taxable bond, you must compute its taxable equivalent yield

7. The formula is as follow:
Taxable Equivalent Yield = Tax-Free Yield /
1 - Your Tax Bracket
Example - Taxable Equivalent Yield
Joe is trying to decide whether he should invest in a corporateor municipal issue.
He is in the 26% tax bracket. The municipal bond is paying 5% and the corporate
issue pays 8%. Which is the best choice?
8% = 5/100 - 26
8% = 5/74
8% = 0.067 or 7%
In this case, the corporateobligation will pay Joe more than the municipal issue.
This is true for most investors in the lower tax brackets.
Corporate bonds
Corporate bonds are the simplest type of bond from a tax perspective, as they are
fully taxable at all levels. Because these bonds typically contain the highest level
of default risk, they also pay the highest rates of interest of any major category of
bond. Therefore, an investor who owns 100 corporate bonds at $1,000 par value

8. each paying 7% annually can expect to receive $7,000 of taxable interest each
year.
Capital gain
Regardless of the type of bonds that are sold, any debt issue that is traded in the
secondary market will post either a capital gain or loss, depending on the price at
which the bonds were bought and sold. This includes government and municipal
issues as well as corporatedebt. Gains and losses on bond transactions are reported
the same as with any other type of security, such as stocks or mutual funds, for the
purpose of capital gain.
Amortisation of Bonds in India
As discussed previously, when a bond is issued at a discount, a prorated portion of
the discount is reported as income by the taxpayer each year until maturity. When
bonds are purchased at a premium (greater than $1,000 per bond), a prorated
portion of the amount over par can be deducted yearly on the purchaser's tax
return. For example, if you buy 100 bonds for $118,000 and hold them for 18 years
until they mature, you can deduct $1,000 each year until maturity. You also have
the option of deducting nothing each year and simply declaring a capital loss when
you redeem the bonds at maturity or sell them for a loss.
However, it is not necessary to amortize premium in the year that you buy the

9. bond; you can begin doing so in any tax year. One important rule to remember is
that if you elect to amortize the premium for one bond, then you must also
amortize the premium for all other similar bonds, both that year and going forward.
Another caveat is that if you do decide to amortize the premium from a bond, you
must reduce the cost basis of your position by an equivalent amount.
Tax Saving Bonds in India:
In India the tax saving bonds are used by the individual tax payers. These have not
been too popular like some other tax saving instruments but are deemed ideal for
tax payers who have lesser propensity to take risks. These bonds are for investors
who look to generate savings in the long run and also enjoy tax benefits at the
sametime.
The tax-saving bonds are not inflation adjusted - the interest rates of these
investment options stay the same in spite of fluctuating inflation rates. This has
contributed significantly to their lesser popularity.

10. These bonds are financially viable if the inflation is on the lower side. However, if
the inflation reaches double digits these investments could become counter-
productive and also reduce the investors' financial worth.
Tax deduction sections:
In India, the following sections of the Income Tax Act of 1961 state the
exemptions and benefits that are to be provided to the tax saving bonds:
 80C
 80CCF
 80CCC
 54EC
 80CCD
Section-80CCF
The Section 80CCF was introduced in the Union Budget for 2010-11. It is
supposed to provide deductions in income tax for investments in long term
infrastructure bonds. In 2010-11 these bonds provided the scope for additional
income tax deductions till INR 20 thousand. This amount has been increased in
the 2011-12 budget as well. This additional amount is above and over the tax
exemption limit of 1 lakh rupees provided under 80C, 80CCD, and 80CCC.
RBI RELIEF FUNDS
The minimum investment limit for these bonds, issued by the RBI, is INR 1000
and the interest of these bonds is compounded every 6 months. These bonds have
a maturity period of 5 years and the interest earned on these bonds is tax free.

11. The holders of these bonds can opt to either receive the interest every 6 months
or after maturity. The half yearly RBI bonds are preferred by investors who want
a consistent and fixed income. The fact that RBI is the apex banking institute in
India makes these bonds a safe investment option.
IDFC Infrastucture Bonds:
Each IDFC infrastructure bond has a face value of 5000 rupees and the minimum
investment limit is INR 10 thousand. Interest can be received after maturity or on
an annual basis. These bonds have a minimum lock-in period of 5 years and they
mature after 10 years
Infrastructure Bonds:
Infrastructure bonds provided by leading private sector banks such as ICICI are
extremely popular among investors. L&T Infrastructure Finance Company is
supposed to come out with the L&T Infra's Long Term Infrastructure Bonds.
These bonds will be providing tax benefits as stated in the Section 80CCF of the
Income Tax Act 1961.
NHA/REC Bonds:
The NHAI/REC bonds offer tax benefits as stated under the Section 54EC of the
Income Tax Act of 1961. Tax payers can save taxes if they invest capital gain
derived from transferring a long term capital asset in REC or NHAI bonds.
These bonds provide yearly interest payments and their maturity period is 3

12. years. Its minimum investment limit is 10,000 rupees.
Investments Eligible for Deductions:
Holders of certain bonds are eligible to claim deduction from their taxable
income. A list of such deposits is mentioned hereunder:
Interest on Government Securities, National Savings Certificate (issues VI, VII
and VIII), Development Bonds, Development Bonds and 7 year National Rural
Development Bonds
Interest on Post Office Term Deposits, Recurring Deposits Accounts and
National Savings Schemes (as referred to in National Savings Scheme Rules,
1992)
Dividends received from a co-operative society
Income from investments in UTI (up to assessment year 1999-2000)
Interest on deposits with a banking company or a co-operative bank

13. Interest on deposits with a co-operative society made by a member of the society
Interest on deposits with housing boards
Interest from deposits made under A.E. (C, D.) Act & C.D.S. (I.T.P.) Act.
Interest on notified debentures of any co-operative society, any institution or any
public sector company.
Interest on deposits with a financial corporation which is engaged in providing
long-term finance for industrial development in India and which is eligible for
deduction under Section 36(l)(viii) [up to assessment year 1999-2000, the
corporation is approved by Central Government].
Interest on deposits with a public company formed and registered in India with
the main object of carrying on the business of providing long-term finance for
construction or purchase of houses in India for residential purposes and which is
eligible for deduction under Section 36(l)(viii) [up to assessment year 1999-
2000, the company is approved by the Central Government under Section
36(l)(viii)].
Interest on deposits with Industrial Development Bank of India.
Interest on deposits under National Deposit Scheme. Income in respect of units
of mutual fund specified under Section 10(23D) [up to assess. year 1999-00].
Interest on deposits under Post Office (Monthly Income Account) Rules.
Section 54EC:
Income tax laws provide exemption on gains from selling property if one invests in
Section 54EC bonds. Such investment has to be made within six months of the date
of sale of the residential property. In April 1, 2007 , a provision was introduced
whereby a maximum of Rs 50 lakh may be invested in such bonds in one financial

14. year. While by no means the amount of Rs 50 lakh is small, especially with respect
to capital gains from property, may just not be enough to cover the entire amount
of gains.
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