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Tax-free bonds in India are popular investment options for investors looking for a tax-efficient
investment option with a fixed rate of interest. However, like any other investment, tax-free
bonds also come with certain risks. In this blog, we will discuss the risks associated with
investing in tax-free bonds in India.
Interest rate risk
The interest rate risk is one of the primary risks associated with investing in tax-free bonds.
Tax-free bonds are long-term investments with a fixed rate of interest. If the interest rates in the
economy rise, the value of the existing bonds falls, leading to a decline in the bond’s market
price. This can result in a capital loss for investors who want to sell the bonds before their
maturity date.
Inflation Risk
Inflation is the rate at which the general price level of goods and services increases in an
economy over time. Inflation can erode the value of money, and the purchasing power of the
interest income earned from tax-free bonds. If the rate of inflation is higher than the interest rate
offered on the bonds, the real returns on the investment can be negative.
Credit risk
Credit risk is the risk of default by the issuer of the bonds. Tax-free bonds are typically issued by
government-backed entities such as NHAI, HUDCO, PFC, and REC. However, there is always a
risk of default by the issuer, which can lead to a loss of capital for investors. Inflation can erode the value of money and the purchasing power of the
interest income earned from tax-free bonds. If the rate of inflation is higher than the interest rate
offered on the bonds, the real returns on the investment can be negative.
Liquidity Risk
Liquidity risk is the risk of not being able to sell the bonds at the desired price or at the desired
time. Tax-free bonds are long-term investments, and investors need to hold the bonds till
maturity to receive the full benefit of the tax-free interest income. However, if investors need to
sell the bonds before their maturity date, they may have to sell them at a discount, which can
result in a capital loss.
Market risk
Market risk is the risk of volatility in financial markets. Tax-free bonds are traded in the
secondary market, and their market price can be affected by various factors such as changes in
interest rates, inflation, and credit rating changes of the issuer. These factors can result in a
fluctuation in the market price of the bonds, which can result in a capital loss for investors.
In conclusion, tax-free bonds in India offer investors a tax-efficient investment option with a fixed
rate of interest. However, investors should also consider the risks associated with investing in
tax-free bonds, such as interest rate risk, inflation risk, credit risk, liquidity risk, and market risk.
Investors should also consider their investment objectives, risk appetite, and investment horizon
before investing in tax-free bonds. It is always advisable to consult a financial advisor or
investment expert before making any investment decision.