Tax Free Bonds in India 2024: Interest rate, Meaning, Features, Example

14 min read • Published 30 October 2022
Written by Anshul Gupta
Tax Free Bonds- Meaning, Features and more

Tax free bonds are fixed income instruments that provide the additional benefit of tax exemption on interest income earned. They are usually issued by governmental bodies – central and state. Tax Free Bonds are considered to be one of the best investment alternatives for long term investing. The availability of ample liquidity for these government securities further adds to the argument for their lucrativeness.

Through the course of this article, we shall try to understand the fundamentals of tax free bonds and their integral features.

What are Tax-Free Bonds?

Tax-free bonds are a form of fixed income securities, generally issued by the government or government-backed companies. You earn a pre-set interest on the bond periodically, and the returns are tax-free. 

As per Section 10(15) of the Income Tax Act, 1961, earnings from such bonds are entirely tax exempt. Just like with any other bond, the issuer repays the face value (principal amount) when the security matures. Generally, such tax-free bonds have a maturity period of ten years or more. These are essentially liquid investments that can be traded in the secondary market.

Typically, these tax-free bonds come with a face value of Rs. 1000. They have a predefined coupon rate. The interest payouts usually occur every six months. When you trade these bonds in the secondary market, it is essential to keep an eye on the bond prices. There is an inverse relationship between bond prices and the underlying interest rates. Thus, when interest rates go down, the bond price goes up, and vice versa.

How Do Tax-Free Bonds Work in India?

The government issues tax-free bonds with the view of raising capital for its operations, such as social programmes or infrastructure development. These bonds resemble regular bonds in most aspects as in they serve as fixed income securities that promise a pre-set periodic return. 

The rate of interest on Tax Free Bonds is dictated by the current yield on prevalent government securities with comparable tenure. Additionally, the credit rating offered by the rating agencies and investors’ qualifications also play an essential role in determining the rate of interest.

Tax-free bonds are a long-term investment tool. Hence, the maturity period can be 10, 15, or even up to 20 years long. If you own such a bond, you can redeem it at its maturity or trade it in the secondary market via stock exchange and thereby benefit from price appreciation. 

If you sell the bond within a year of the purchase, the profit earned is added to your taxable income. If you sell it after one year, you incur a long-term capital gain tax without indexation benefit, which is capped at 10%. The tax with indexation benefit is capped at 20%. Section 112 of the Income Tax Act, 1961, governs the profit made from the sale of these tax-free bonds.

Also Read: Key Differences between the Primary Market and Secondary Market

What are The Common Types of Tax-Free Bonds?

Tax-free bonds are a popular mode of diversifying investment in the bond ecosystem, given the tax benefit you get from investing in them. Here are some of the most common Tax-free bonds that are popular in India:

IRFC Bonds: IRFC stands for Indian Railway Finance Corporation. The bonds that the IRFC offers are a staple in the country’s tax-free bond ecosystem, given the fact that this money is used to finance the expansion and maintenance of the railway system in India.

PFC Bonds: PFC stands for Power Finance Corporation, and the proceeds from selling these bonds funnel into the development of various power projects across the country. If you’d like to have a power development stamp in your investments, these are a great choice.

REC Bonds: REC stands for Rural Electrification Corporation. The proceeds from these bonds are used to fund various electrification projects across the country.

NHAI Bonds: NHAI is a popular acronym for the National Highways Authority of India. The funds raised for building and maintaining the highways across the country come from these bonds.

Features of Tax-Free Bonds

The following are the critical features of tax-free bonds in India:

Tax exemption

The most significant advantage of investing in these government-backed securities is that the interest earnings are entirely exempt from income tax. There is no TDS on these bonds as well. Even though the income from these bonds is tax-free, experts advise declaring the yields at the time of tax filings. One key point to note here is that the investment amount does not qualify for any tax deduction. It is only the returns that are exempt from tax. Compared to fixed deposits (FDs), you stand to benefit more by investing in these bonds if your tax bracket is high.

Risk

In terms of risk, tax-free bonds enjoy government backing and hence they are considered as one of the safest investment options.This perk is in addition to that of capital protection by virtue of the fixed nature of earnings. Tax free bonds are still however susceptible to inflation and reinvestment risk.

Tenure

Tax-free bonds have a longer maturity period—ranging from 10 years or more, and the tenure can go as far as 20 years. You cannot redeem the bond or withdraw money before it matures. However, these tax-free bonds can be traded in the secondary market. Because of their long tenure, these bonds are not ideal for short-term investments. It is also prudent to note here that no tax benefit can be availed on profits made through price appreciation. Tax exemption can be availed only on interest income.

Liquidity

Tax-free bonds offer moderate liquidity. Liquidating your position might prove to be tedious considering their long tenure. However, these securities can be traded in the secondary market. There are limited buyers and sellers for such assets. Hence, the trade volume is lower.

Returns

The coupon for the bond is predetermined. Returns on these secondary market traded instruments are also largely affected by the purchase price. You can generate gains by selling the bond at a premium in a favourable market but this gain is not eligible for any tax benefit of sorts.

Interest

Since they are fixed-income security, you are guaranteed to earn interest on these government-backed securities. The tax-free bonds in India typically offer a guaranteed interest rate ranging from 5.50% to 6.50%. The government decides the coupon rate at the time of issuance. After the investment, you receive annual tax-free interest payments.

Bond Issue

As you may have understood by now, tax-free bonds are issued either directly by the government or by the government-backed companies. The issue of such tax-free investment securities is open for only a limited time. You can subscribe to these bonds online through your demat account or physically submit the subscription format the time of initial brief issuance or you can also purchase these bonds in the secondary market as they are tradable on the stock exchange.

Also Read: Long-Term Capital Gains Tax Exemption – List of Exemptions as per IT Act

Benefits of Tax-Free Bonds

Tax-free bonds come with multiple benefits across a wide range of people; let’s take a look at some major ones:

Locking it in Long-term: These tax-free bonds are pretty lucrative if you think long-term. Most exist for 10 to 20 years, making them a great fit for those who don’t want their money moving around too much.

Getting A Liquidity Fix: Worried about locking away your money? While these bonds are primed to play the long game, they’re also listed on big stock exchanges. So, you can always sell them if you ever get a cash crunch.

Safety: Let’s be real. Safety is key. Most of these bonds are backed by the government and heavyweight PSUs. So, they’re safer than some in the private sector.

Regular Income: If you’re looking for some steady cash flow? These bonds have your back. They’ll serve you a fixed interest throughout your life. Think of it as getting your favourite subscription box, but it’s money.

Big Tax Savers, Especially for the High Rollers: If you’re in a higher tax bracket, these bonds are basically like a golden ticket. This is due to the because of Tax-free interest you earn. Yep, you heard right. That means your take-home is often way better than other taxable instruments.

Tax-Free Throughout: The interest from these bonds is completely tax-free, making them one of the most attractive forms of investment in the bond sector for people to consider.

Who Should Invest in Tax-Free Bonds?

If you are an investor with a long-term investment horizon, require capital safety, and regular interest payout, tax-free bonds can be an excellent mode of investment. Also, these bonds are a great investment vehicle for senior citizens. Due to the tax-free returns, you can invest a huge lump sum amount and earn regular interest in the form of absolute returns.

The following are the different investor categories that are allowed to invest in tax-free bonds:

  • Retail investors, including non-resident Indians (NRI) and Hindu Undivided Family (HUF)
  • High net worth individuals (HNIs) with a low-risk tolerance and the ability to invest up to Rs. 10 lakhs
  • Corporates, regional rural banks, co-operative banks, trusts, partnership firms, limited liability partnerships, and other legally authorised entities
  • Qualified institutional buyers (QIBs) defined by the Securities and Exchange Board of India (SEBI) Guidelines, 2000

Taxation Implications If the Bond is Sold Before The Maturity Date

If a bond is sold off quickly before the maturity date to meet some liquidity needs, here are the following that entails on a taxation note:

Short and Long-Term Capital Gains: To keep it simple, the proceeds earned from selling a bond within 12 months of the purchase date are called short-term capital gains. The gains are added to the investor’s overall income and taxed accordingly. If it is sold after 12 months from the date of purchase, the proceeds are known as long-term capital gains.

For listed bonds (which most tax-free bonds are, as they are traded on stock exchanges), the LTCG tax is 10% on gains exceeding ₹1 lakh in a financial year, without the benefit of indexation.

Losses from Premature Sale of the Bond: If you sell the bond before its due date and face a loss (whether it’s a loss from a quick sale or a longer-held bond), you can use that loss to reduce any profits you’ve made from other investments. And if you can’t use up all that loss in one go, you can turn it over and deduct it from profits in the coming years.

How to Invest in Tax-Free Bonds

With growing digitization, investing in tax-free government bonds has become hassle-free. As mentioned earlier, these government securities can be subscribed to online and offline. 

For instance, if the government offers the issue for a limited time, you can subscribe to it through your Demat account. If you wish to subscribe to the issue physically, you must fill out the subscription form and submit the same during the given window. You will also need to submit documents such as your permanent account number (PAN) and banking information such as the account number and IFSC.

There is another way to invest in these tax-free bonds: if you miss out on a subscription during the initial issue, you can purchase the bond in the secondary market. These bonds are traded on the stock exchange and can be bought through your trading account.

How to Redeem Your Tax-Free Government Bonds?

As an investor, you should know that you can only redeem tax-free government bonds at the time of maturity. The issuing body will not buy back the bond at any point. 

However, you can sell these bonds in  the secondary market. As mentioned earlier, short-term and long-term capital gains taxes are imposed  on the trading of these tax-free bonds. 

 The government of India hasn’t issued any new tax-free bonds since 2016. Thus, you should be aware of the prevailing term and interest rate if you consider the ones issued by PSU-backed companies.

The Advantages of Tax-Free Bonds

The following are the primary advantages of tax-free bonds: 

  • The biggest advantage of tax-free government bonds is that the interest income is entirely tax exempt. 
  • These bonds are government-backed, so you can consider investing higher amounts.
  • Another critical benefit of tax-free bonds is that the returns are directly credited to your bank account. Generally, these interest payouts occur annually or half-yearly.
  • If you have a long investment horizon, tax-free bonds can be an excellent source of income with guaranteed repayment at maturity.

What is the Difference Between Tax-Free Bonds and Tax-Saving Bonds?

Differentiating PointTax-free bondsTax saving bonds
InterestInterest can be paid every six months or annually. Also, the rate of interest is higher compared to other tax-saving bonds. An additional advantage of earning tax-free interest on investment is present.Interest payout can be annual or as per the terms set by the issuer. The rate of interest is slightly lower than  tax-free bonds.
TenureLong-term ,investment tenure ranges from 10 to 20 years.These are medium to long-term investments with a term of 5 to 10 years.
Tax Rebate on Investment AmountThe investment amount does not qualify for a tax deduction. Only the interest earned is tax-freeUnder Section 80CCF, you can reduce your taxable income upto Rs. 20,000 by investing in these bonds. This is over your standard 80C limit of 1.5 lakh.
General TaxationYou incur a capital gains tax if you trade these bonds in the secondary market.The interest earned on a tax-saving bond is taxable per your tax slab. Principal amount upto Rs. 20,000 is tax deductible.
Lock-In PeriodNo lock-in period as they are tradable in the secondary market Lock-in period of five years

Conclusion

Just like any other type of bond, tax-free bonds are low-risk investments. It can be an ideal investment if you have a long-term investment horizon and want to earn tax-free interest income. However, consider your financial objectives and obligations before investing in these bonds. Consult with your financial adviser if necessary.

FAQs about Tax free bonds

Are Tax-Free bonds and Tax-Saving bonds the same?

No. Only the interest earned on the investment amount is tax-free in tax-free bonds. On the other hand, investing in tax-saving bonds can help you reduce your taxable income up to Rs. 20,000 beyond the standard Rs. 1.5 lakh limit defined under Section 80C. The interest earned on tax-saving bonds is taxable per your tax bracket.

What is the difference between a tax-free bond and an RBI  Savings (taxable) bond?

RBI savings (taxable) bonds have a compulsory lock-in period of 7 years while giving an interest rate of 7.75%. An RBI taxable bond offers no tax-saving option to you as opposed to a tax-free bond. A tax free bond on the contrary can be sold off in the secondary market with much ease and the interest income is entirely tax free.

How to calculate my interest on the tax-free bonds?

You can calculate the interest on your tax-free bonds by multiplying the coupon rate with the bond’s par value.

What is an example of a tax-free bond?

An example of a tax-free bond is bonds offered by municipal corporations.

Is it good to invest in Tax-free bonds?

Using tax-free bonds, you can profit from not paying taxes on the interest you earn on your investment. Additionally, the bonds are a generally safe investment because a business, financial institution, or the government issued them.

What is the limit of tax-free bonds?

The annual maximum investment amount for tax-free bonds in India is INR 5 lakh. You are allowed to invest in an unlimited number of tax-free bonds. However, you can only get a tax exemption up to the annual maximum investment amount of INR 5 lakh.

How to buy Government Tax-free bonds?

You can buy Government Tax-free bonds through stock exchanges.

Can individual investors invest in tax-free bonds?

Yes, individual investors can invest in tax-free bonds in India.

Which are the best tax-free bonds in India?

The best tax-free bonds vary based on market conditions, but ones issued by NHAI, PFC, IRFC, and HUDCO are generally sought-after.

Is a Demat account needed for tax-free bonds?

No, a Demat account isn’t mandatory for tax-free bonds, but it’s convenient if you plan to trade them on stock exchanges.

What are the tax-free bonds popular among investors?

Tax-free bonds from entities like NHAI, PFC, IRFC, and HUDCO are popular among investors.

What types of investors are suitable for tax-free bonds?

Tax-free bonds are suitable for investors seeking a stable, long-term, and tax-efficient source of income, especially those in higher tax brackets.

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Anshul Gupta

Co-Founder
IIT Roorkee Alumnus and CFA with experience of structuring debt products worth more than 15000Cr for institutional and retail investors.

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