People seek investment options that provide them with good financial returns. Zero tax on the returns among other benefits make tax-free bonds a sought-after investment. Hence, in this article, we will cover the following aspects about these low-risk bonds.

  1. What are tax-free bonds?
  2. Who should invest in tax-free bonds?
  3. Features & benefits of tax-free bonds?
  4. Common government tax-free bonds?
  5. Tax-free bonds vs tax-saving bonds
  6. How to invest in tax-free bonds?
  7. How to redeem your tax-free bond?


1. Tax-free bonds 

Tax-free bonds are types of goods or financial products, which the government enterprises issue. One example for this is the municipal bonds. They offer you a fixed interest rate, and hence is a low-risk investment avenue. As the name suggests, its most attractive feature absolute tax exemption. This is as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of typically ten years or more. Government invests the money collected from these bonds in infrastructure and housing projects.

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2. Who should invest in tax-free bonds?

Tax-free bond is a good choice for an investor who wants to earn fixed annual income from the interest proceeds. They should also be willing to lock their money for a longer maturity period – at least 10 years. Therefore, these bonds suit people with a low-risk profile, who can afford a long-term lock-in period.

Qualified Institutional Investors defined by SEBI under the Disclosure and Investor Protection Guidelines can invest in these bonds. Partnership companies & limited liability groups are also eligible. Entities like trusts, co-operative & regional banks and corporate companies too are regular investors in tax-free bonds. Individuals including HUF members and NRIs as well as high net-worth individuals often choose this to diversify their portfolio.


3. Features & benefits of tax-free bonds

a. Tax-exemption

The income you earn in the form of interest is entirely free from income tax. There is no tax deducted at source (TDS) either. This doesn’t mean that you can claim the investment amount for the tax deduction. Hence, you must always declare the interest as income. However, compared to the bank FDs, tax-free bonds offer great benefits to investors who are in the high tax bracket.

b. Interest

These bonds currently offer 6.5% rate, which is fairly attractive you consider the tax-exemption. The bondholder receives the interest annually. The rates are subject to fluctuations as they are related to the current rate of the government securities.

c. Risk factors

Chances of defaulting on interest payment is very low as these schemes are from the government itself. It also offers capital protection and a fixed annual income. Hence, it is quite safe.

d. Liquidity

You cannot liquidate tax-free bonds as easily as, say, debt funds. This is because these government bonds are long-term investments and have longer lock-in periods. So, do not treat this as an emergency fund.

e. Lock-in tenure

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

f. Issuance & transaction

They issue tax-free bonds using a demat account or in physical mode, and trade in stock markets. Hence, the interest you earn on these bonds is tax-free. However, the capital gain from selling these bonds in stock markets is taxable.

g. Returns

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

Tax-free bonds

4. Examples of Government tax-free bonds

There are many public undertakings that offer and issue tax-free bonds. National Highway Authority of India, NTPC Limited and Indian Railways, Rural Electrification Corporation are some of the widely known ones. Housing and Urban Development Corporation, Indian Renewable Energy Development Agency, Rural Electrification Limited and Power Finance Corporation are other examples. Therefore, you must always check the authenticity before buying.


5. Tax-free bonds vs tax-saving bonds

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 lakhs 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, availing the investment opportunities in these bonds are simple and highly rewarding. Remember, the subscription period for the investment is open only for a specific time. You must submit your PAN Number if buying the physical format.

When the government releases them to the public, the investor can conduct the trading by applying online or offline. On the other hand, if the investor applies for the bond post issuance, he/she can invest using the trading account. Hence, this is not unlike trading shares in stock markets.


7. How to redeem your tax-free bond

Redeeming the tax-free bond is not difficult if you have completed the tenure. However, you cannot withdraw your bond before 10-20 years, only trade it on stock exchanges to another investor. The entity that issued the bond in the first place cannot buy it back either. And the profit you make after the sale is 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 without indexation will attract 10% LTCG on gains. With indexation, the tax will be 20% post one year.


Conclusively, the options to invest in 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 tenure and interest rate if they are considering those by PSU companies.

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