How is yield of tax exempt bond different from the effective yield of taxable bond?
When we are comparing the yield of tax free bonds and the net yield of the normal taxable bonds, the applicable tax rate can directly influence the final returns that will be generated for the investors. To get a better idea about the investment returns, it is important to focus on the post-tax, net returns generated by the different financial instruments.
In most countries, the interest amount received from Bonds is taxable in the hands of the investor. However, there is also a concept of Tax-free Bonds in some regions, to focus on lending in some strategic sectors. For these Bonds, the interest amount received by the investor is exempted from income tax.
On this page, we try to explain how the Tax Free Bond Yield should be compared with the after-tax yield of the taxable Bonds. This will give a better picture about the actual returns of tax free bonds, when compared to other investment options.
Interest payment in Bonds
The Bond Coupon is the primary way through which the investors make returns in Bonds. The Coupon is the interest payments that the borrower (Bond issuer) will make to the investors, at regular intervals. The principal amount in Bonds is usually repaid at the maturity time. (Refer: What is Coupon frequency in bonds?)
This defined Coupon Rate and the Coupon payment frequency are fixed at the Bond issuance time, and these usually do not change during the lifecycle of the Bond. These can help to calculate the exact amount that the investor will receive, at different time intervals.
Example: Suppose that a Bond has a Face Value of INR 100, a Coupon Rate of 14% (semi-annual), and a borrowing duration of 2 years. In this case, the investor would receive a Coupon of INR 7 at the end of 6 months, another coupon of INR 7 at the end of 12 months, INR 7 again at the end of 18 months, and INR 107 at the end of 2 years (Principal + Coupon).
Note: The concept of Coupon payments does not apply to the Zero-Coupon Bonds. The investment returns generated in this type of bonds is through price appreciation and Capital Gains.
Effect of Taxes on Yield
The Coupons are considered to be interest payments on the borrowed amount. In most countries, the received interest is treated as an income for the investor, and taxes are applicable on this amount.
In India, the interest income is taxable at the Slab Rates of the investor. This means that if an investor falls in the 30% tax bracket, then he/she will have to pay 30% tax on the received Coupon amount. Similarly, if the annual income of the investor is below the taxable limit, then he/she does not have to pay any taxes on the income from the Bond.
So, it should make inherent sense that the applicable tax rates have a significant impact on the net returns that are generated by any financial instrument.
Example: Suppose that a Bond is purchased at a price of INR 1,000, and it pays an annual Coupon of 9%. Let us assume that the investor has to pay 30% tax on the received interest/Coupon.
The Current Yield of the Bond will be 9%. After adjusting for taxes, the net annual yield for the investor will become:
9% X .07 = 6.3% (assuming no compounding of interest)
Tax-Free Bonds
The receiver does not have to pay any Income tax on the interest amount/Coupon amount that is paid by a Tax-Free Bond. This tax advantage has the potential to make the net yield of Tax Free Bonds higher than the other investment options available in the market.
These special types of Bonds are used to boost lending in some strategic and priority sectors that the government is focusing on. For example, some Sovereign Green Bonds, Highway Construction financing Bonds, Power sector financing Bonds etc. are usually made tax-exempt for individuals.
Note: Even though the interest is tax exempt, but the investor would still need to disclose the Tax Free Bonds returns as an income in their Income Tax forms. So, please check the local taxation laws applicable in your region.
Tax free Bond returns example
Suppose that a Tax-free Bond offers a Coupon Rate of 7%, and a similar duration taxable Bond offers an annual Coupon of 8%. An investor who falls in the 20% tax slab would like to explore which Bond will offer a better yield (assuming no compounding of interest).
At first glance, it might appear that the tax-free Bond is offering a lower return (7% vs. 8% for the taxable Bond). However, if we consider the impact of income tax on the investor, then the taxable bond will offer 8% X 0.8 =6.4% returns.
Whereas the final yield of tax free bonds would still be 7% (since no income tax is applicable on this). So, the tax-free bond might be a better investment in this case. (Assuming both Bonds have same Credit Rating, and similar borrowing terms)
Net yield of Tax free Bonds and Taxable Bonds
When we are focusing on the net Bond Yield, it is possible that the post-tax yield of a Bond could be lower than a similar Tax Exempt bonds yield. The Coupon Rate just indicates what interest amount will be paid by the borrower (Bond Issuer). But it does not mean that the Bondholders will make the exact same investment returns.
So, the interest amount that is received by the investor, should be adjusted according to the tax, and other deductions that the investor would need to pay. Let us do a side-by-side comparison of 2 similar bonds, to understand how the yield of tax-free bonds can be compared with taxable Bonds.
(Assuming that the 2 Bonds are exactly same, and the only difference is in the tax treatment of the Coupon)
| Taxable Bond (0% tax rate of investor) | Taxable Bond (10% tax rate of investor) | Taxable Bond (30% tax rate of investor) | Tax-free Bond | |
| Face Value (INR) | 1,000 | 1,000 | 1,000 | 1,000 |
| Coupon Rate | 9% | 9% | 9% | 9% |
| Coupon Amount received by investor (INR) (A) | 90 | 90 | 90 | 90 |
| Income Tax rate of the investor | 0% | 10% | 30% | NA |
| 0 | 9 | 27 | 0 | |
| Health and Education Cess, and any other Surcharge applicable on tax (C) | 4% of B (INR 0) | 4% of B (INR 0.36) | 4% of B (INR 1.08) | 4% of B (INR 0) |
| Total tax payable (INR) (D = B + C) | 0 | 9.36 | 28.08 | 0 |
| Amount received by Bondholder (INR) (A – D) | 90 | 80.64 | 61.92 | 90 |
| Effective Yield | 9% | 8.06% | 6.19% | 9% |
Note: The table is an indicative example, and it will only give a rough estimation of the after-tax yields in different scenarios. When calculating the tax free bond yield in this way, the concept of Time Value of Money is ignored.
eXtended Internal Rate of Return (XIRR)
In the above-mentioned estimation method, it is assumed that the entire tax will be paid as soon as the interest is paid out. However, in real life there will be a time gap between the payment of the interest/Coupon, payment of taxes, and deduction of TDS (Tax Deducted at Source).
So, the above method will not give an accurate measurement about the yield of Bond. Instead, one of the most precise methods to compare yield of tax free bonds and taxable bonds is to use the eXtended Internal Rate of Return (XIRR) concept.
The main benefit of post-tax XIRR is that it gives an annualized rate of return, depending on the exact date of the cashflow. This makes the calculations accurate for taxable bonds, because the time gap between the cashflows might not be fixed.
Using XIRR for Tax Free Bonds yield
Let us use a simple example to better explain how to measure and compare the Tax free equivalent yield.
Example: Suppose that we have 2 similar Bonds with same Credit Rating, and both pay a Coupon of 12% annually. Let us assume that an investor falls in the 30% Income Tax bracket, and the interest payment is subject to a TDS of 10% (Tax Deducted at Source). He/she is subscribing to the Bonds on the date: 08 Jan 2030, and maturity date is 08 Jan 2032. The investor wants to compare the yield of tax free Bonds and the taxable Bonds.
In the below table, we first list down the Cash Flows of the 2 Bonds on the different dates. A positive Cash Flow indicates money flowing to the investor, and a negative value means that the money is paid by the investor. The XIRR formula in Microsoft Excel can be used to measure the rate of return in these 2 cases.
| Event | Date | Cash Flow for Taxable Bond | Cash Flow for Tax-free Bond |
| Initial investment by investor (INR) (Face Value of Bond) | 8-Jan-2030 | -1,000 | -1,000 |
| Coupon payment (INR) | 8-Jan-2031 | +120 | +120 |
| 10% TDS deducted at Coupon payment time (INR) | 8-Jan-2031 | -12 | 0 |
| Balance Tax payment by investor (INR) (Assuming 30% tax rate) | 15-Mar-2031 | -24 (Total INR 36 – TDS of INR 12) | 0 |
| Coupon + Principal (INR) | 8-Jan-2032 | +1,120 | +1,120 |
| 10% TDS deducted at Coupon payment time (INR) | 8-Jan-2032 | -12 | 0 |
| Balance Tax payment by investor (INR) (Assuming 30% tax rate) | 15-Mar-2032 | -24 | 0 |
| XIRR: | 8.44% | 12.00% |
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