Tax-Free Bonds: Meaning, How to Invest and More

Updated on: Jan 18th, 2023


7 min read

People are always after investment options that provide good returns. Zero tax on returns, among other benefits, makes tax-free bonds one of the most sought-after investments in the market. 


What are Tax-Free Bonds

Tax-free bonds are issued by a government enterprise to raise funds for a particular purpose. One example of these bonds is the municipal bonds issued by municipal corporations. They offer a fixed interest rate and rarely default, hence are a low-risk investment avenue.

As the name suggests, its most attractive feature is its absolute tax exemption on interest as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of ten years or more. The government invests the money collected from these bonds in infrastructure and housing projects.

Who should invest in Tax-Free Bonds

Tax-free bonds are an excellent choice for investors looking for fixed income like senior citizens. As government enterprises typically issue these bonds for a longer tenure, default risk is very low in these bonds and you are assured of a fixed income for a more extended period, typically ten years or more.

The government enterprises invest the money collected through the issuance of these bonds in infrastructure and housing projects. Tax-free bonds are the right choice for investors falling in the highest tax bracket.

Typically high net-worth (HNI) individuals, HUF members, trusts, co-operative banks, and qualified institutional investors prefer to invest in tax-free bonds.

What are the features of Tax-Free Bonds


In the case of tax-free bonds, the interest income is entirely tax-exempt. Also, the tax deducted at source (TDS) does not apply to these bonds. However, it is advisable to declare your interest income as the principal amount invested in tax-free bonds do not qualify for a tax deduction under Section 80C.

You may purchase tax-free bonds in both, physical and the Demat form. Tax-free bonds, when compared to bank FDs, offer a tax-efficient return to investors who fall in the highest income tax brackets.

Risk factors

Chances of default on principal and interest payment are very low as these schemes are issued on behalf of the government itself. Also, it offers capital protection and a fixed monthly or annual income. Hence, it can be considered quite safe.


You cannot liquidate tax-free bonds as quickly as, say, debt mutual funds. Since government bonds are long-term investments and have more extended lock-in periods, liquidation of the tax-free bonds may not be that easy.

Lock-in tenure

Tax-free bonds have a longer lock-in period that ranges from 10 years to 20 years. You cannot withdraw your money before the maturity date. Therefore, please make sure that you do not need this money shortly after investing.

Issuance & transaction

Tax-free bonds are issued through a Demat account or in physical mode. You may buy tax-free bonds from the secondary market to achieve short-term financial goals.


The returns you make on these bonds are primarily dependent on the purchase price. This is because they are traded in low volumes with a limited number of interested buyers or sellers.


The rate of interest offered on tax-free bonds generally ranges between 5.50% to 6.50%, which is fairly attractive when considering the tax exemption on interest for these bonds.

A bondholder receives the interest annually. However, the rates are subject to fluctuations as they are related to the current rate of government securities. You could get a 6% tax-free return if you invest in tax-free bonds at current yields.


What are the commonly found Tax-Free Bonds

Many public sector undertakings issue tax-free bonds. National Highway Authority of India, NTPC Limited, Indian Railways, and Rural Electrification Corporation are some of the most prominent ones.

Housing and Urban Development Corporation, Indian Renewable Energy Development Agency, Rural Electrification Limited, and Power Finance Corporation are the other examples.

Difference between Tax Free bonds and Tax Saving bonds

Tax-free Bonds

Tax-saving Bonds

Interest (income) you earn is tax-exempt

Just the initial investment is tax-exempt

Falls under Section 10 of the Income Tax Act

Falls under Section 80CCF of the Income Tax Act

Offer higher interest rates than tax-saving bonds

Lower interest rates compared to tax-free bonds

Can invest up to Rs 5 lakh

Tax-exemption is only up to an investment of Rs 20,000 per financial year
The higher maturity period of 10,15 and 20 years
Has a buyback clause – you can redeem investments after 5 or 7 years

How to invest in Tax-Free Bonds

Tax-free bonds have trading options that allow bond trading through a Demat account or in physical form. Therefore, investing in these bonds is simple and highly rewarding. Remember, the subscription period for the investment is open only for a specific time.

You must submit your PAN details when opting for the physical format and do your KYC. When the government issues bonds to the public, the investor can subscribe by applying online or offline.

On the other hand, if an investor requests for the bond post-issuance, investment is through the trading account. Hence, it is similar to trading shares in a stock market.

How to redeem your Tax-Free Bonds

Redeeming tax-free bonds is a fairly simple process, provided you have completed the tenure. However, you cannot withdraw your bond before 10-20 years, but only trade it on stock exchanges with other investors.

The entity that issued the bond in the first place cannot repurchase it either. Moreover, the profit you make after the sale is also taxable under Section 112. Hence, the capital gains you get after selling the bond before one year are taxable as per your income tax slab.

Trading it after one year will attract a long-term capital gains tax at 10%, and there is no benefit of indexation provided. To conclude, tax-free bonds offer tax-free income at low risk.

You can trade these bonds in secondary markets before the maturity period. However, the government hasn’t notified of the issuance of these bonds since 2016. So, investors need to be aware of the tenure and interest rate if they are considering those by PSU companies.

Related Articles

What is NABARD notified bonds? How does it work?

Municipal Bonds: Definition, How They Work & Taxability?

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Quick Summary

Tax-free bonds are government-issued bonds that offer fixed interest rates, low risk, and tax exemption on interest under Section 10 of the Income Tax Act. They are ideal for investors seeking fixed income, have long lock-in tenures, low default risks, and are primarily purchased by HNIs and institutions. Features include tax exemption, low default rates, liquidity challenges, long lock-in periods, and trading options through Demat or physical form.

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