People are always after that 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. We have covered the following in this article:

1. 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. They offer a fixed interest rate and hence is a low-risk investment avenue. As the name suggests, its most attractive feature is its absolute tax exemption 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.

2. 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 less 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 these bonds.

3. What are the features of Tax-Free Bonds?

a. Tax-exemption

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 advised to declare your interest income as tax-free bonds do not imply that you can claim the investment amount for the tax deduction. Tax-free bonds, when compared to bank FDs, offer great benefits to investors who fall in the highest tax brackets.

b. Risk factors

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

c. Liquidity

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

d. Lock-in tenure

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

e. Issuance & transaction

Tax-free bonds are issued through a Demat account or in physical mode. They mainly trade in stock markets.

f. Returns

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.

g. Interest

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 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.

4. 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 popular ones. Housing and Urban Development Corporation, Indian Renewable Energy Development Agency, Rural Electrification Limited, and Power Finance Corporation are the other examples. Therefore, you must always check the authenticity before buying.


Tax-free Bonds Tax-saving Bonds
Interest (income) you earn is tax-exempt Just the initial investment is tax-exempt
Section 10 of the Income Tax Act Section 80CCF of the Income Tax Act
Offer higher interest rates than tax-saving bonds Lesser interest rates compared to tax-free bonds
Can invest up to Rs.5 lakh Tax-exemption is only up to Rs.20,000 investment
Higher lock-in period from 10 years Has a buyback clause – you can withdraw investments after 5 or 7 years


6. 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 will be required to submit your PAN details when buying the physical format.

When the government releases them 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, he/she can invest using the trading account. Hence, it is much similar to trading shares in a stock market.

7. How to redeem your Tax-Free Bonds?

Redeeming tax-free bonds is a fairly easy process, provided you have completed the tenure. However, you cannot withdraw your bond before 10-20 years, but only trade it on stock exchanges to another investor. 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 gains you get after selling the bond before one year is 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 fixed tax-free income at low risk. They are easily liquid via trading of these bonds in secondary markets before the maturity period. However, the government hasn’t notified on 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.

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