What are Tax-Free Bonds

Tax-free bonds provide fixed interest income that is exempt from income tax, subject to the applicable conditions under Section 10(15) of the Income Tax Act, 1961.

• They are generally issued by government-backed entities and public sector undertakings.
• Their maturity period commonly ranges from 10 to 15 years.
• Interest may be paid annually or semi-annually.
• Listed bonds can be traded through a Demat and trading account.
• Capital gains from selling the bonds may still be taxable.
• Investors should assess credit risk, liquidity risk, interest rate risk, and market prices.
   

Tax-free bonds are issued by entities that are backed, established, or incorporated by the government. They raise funds for projects related to national development, infrastructure, power, housing, and transport.

• Common issuers have included:
• National Highways Authority of India
• Power Finance Corporation Limited
• India Infrastructure Finance Company Limited
• Housing and Urban Development Corporation Limited
• Indian Renewable Energy Development Agency Limited
• Rural Electrification Corporation Limited
• National Housing Bank
• NHPC Limited
• NTPC Limited

These organisations use the money raised through bonds to finance projects within their respective sectors.
Government ownership may reduce credit risk, but it does not remove it completely. Investors should review the issuer’s credit rating, repayment capacity, and financial position before investing.
 

Tax-free bonds may be classified according to the sector or activity for which the funds are raised.

1. Infrastructure bonds

Infrastructure bonds finance projects such as roads, bridges, airports, ports, and power facilities.

2. Housing bonds

Housing bonds are issued by housing and urban development institutions. They may finance affordable housing and urban development projects.

3. Power bonds

Power-sector organisations issue these bonds to support power generation, transmission, distribution, and renewable energy projects.

4. Railway bonds

Railway-related entities may issue bonds to finance railway expansion, electrification, modernisation, and network development.

5. Public sector unit bonds

Government-owned companies issue these bonds to raise funds for projects related to infrastructure, housing, power, and other public services.
A bond is not automatically tax-free because it is issued by a government-related organisation. The particular bond issue must qualify for the tax exemption specified under the applicable provisions.
 

When you invest in a tax-free bond through your Demat account, you lend money to the issuer for a fixed period. The issuer pays interest according to the coupon rate mentioned in the bond documents.
The process generally works as follows:

1. Buy the bond: Purchase it during a public issue or through the secondary market.
2. Receive interest: The issuer pays interest annually or semi-annually.
3. Claim the exemption: Eligible interest income is exempt under Section 10(15).
4. Hold or sell: Keep the bond until maturity or sell it on the stock exchange.
5. Receive the principal: The face value is repaid at maturity, subject to the issuer meeting its obligations.

The market price of a listed bond may rise or fall after issuance. It is influenced by prevailing interest rates, market demand, remaining maturity, liquidity, and the issuer’s credit profile.
For example, when market interest rates rise, an older bond with a lower coupon may become less attractive. Its market price may consequently fall.
 

Consider the following factors before investing:

• Investment goals: Decide whether you want regular income, capital preservation, tax-efficient interest, or diversification.
• Investment horizon: Tax-free bonds usually require a long-term commitment.
• Coupon rate: Check the fixed interest rate offered by the issuer.
• Yield to maturity: Evaluate the expected annualised return when buying the bond from the secondary market.
• Credit rating: Review the issuer’s credit rating and financial position.
• Market price: A bond purchased above its face value may provide a lower effective return.
• Liquidity: Low trading volumes may make it difficult to sell the bond quickly.
• Interest rate risk: Bond prices may decline when prevailing interest rates increase.
• Tax treatment: Interest may be exempt, but capital gains from selling the bond can be taxable.
• Bond terms: Read the offer document for the maturity, face value, payment dates, and redemption conditions.

Investors should compare tax-free bonds with fixed deposits, government securities, corporate bonds, and other fixed-income options before making a decision.
 

Read more: Form 10BB 
 

Tax-free bonds and tax-saving fixed deposits provide different tax benefits.
 

Tax-saving fixed deposits may help eligible taxpayers claim a deduction under Section 80C, subject to applicable limits and conditions. However, the interest earned remains taxable.
Tax-free bonds do not usually provide a deduction on the invested amount. Their main advantage is the tax exemption available on qualifying interest income.
 

New tax-free bonds can be purchased when an authorised issuer opens a public issue. Existing listed bonds may also be purchased from the secondary market.

1. Open a Demat and trading account

A Demat account holds the bonds electronically. A trading account allows you to place orders on the stock exchange.

2. Select a suitable bond

Review the available tax-free bonds and examine:

• Issuer
• Coupon rate
• Maturity date
• Credit rating
• Face value
• Current market price
• Trading volume
• Interest payment date

3. Confirm the tax status

Verify whether the specific bond series qualifies for tax exemption under Section 10(15). Not every bond issued by a public sector entity offers tax-free interest.

4. Check your eligibility

Eligibility conditions may vary by issue. Individuals, Hindu Undivided Families, and Non-Resident Indians may be permitted to invest, subject to the issuer’s terms.

5. Evaluate the yield

The coupon rate may differ from the actual return when a bond is purchased above or below its face value. Check the current yield and yield to maturity.

6. Place an order

Enter the required quantity and price through your trading account. The transaction will be completed when a matching seller is available.

7. Receive the bonds

After settlement, the bonds are credited to your Demat account.

8. Receive interest payments

Interest is credited to the registered bank account annually or semi-annually, according to the bond terms.

9. Hold, sell, or redeem

You may hold the bond until maturity and receive the principal amount. You may also sell it before maturity, although the selling price may be higher or lower than the purchase price.
Review the offer document and applicable tax rules before investing.
 

The main features include:

1. Tax exemption

Interest income from eligible tax-free bonds is exempt from income tax under Section 10(15).

2. Fixed maturity

Tax-free bonds generally have maturity periods ranging from 10 to 15 years.

3. Fixed interest rate

The coupon rate is fixed at issuance. However, the effective return depends on the price paid in the secondary market.

4. Issue-specific investment limits

The minimum and maximum investment amounts depend on the individual bond issue. Investors should check the offer document for exact limits.

5. Portfolio diversification

Tax-free bonds can add fixed-income exposure to a portfolio containing equities, deposits, mutual funds, or other assets.

6. Stock exchange listing

Many tax-free bonds are listed on recognised stock exchanges, allowing investors to buy or sell them through a Demat and trading account.

7. Relatively low credit risk

Many issuers are government-backed institutions. However, investors should still assess the issuer’s credit rating and repayment capacity.

8. Limited liquidity

Listing does not guarantee immediate sale. Some bonds may have low trading volumes or wide differences between buying and selling prices.

Read more: TDS Return Form

 

Tax-free government bonds may offer the following benefits:

1. Regular income

The fixed coupon can provide annual or semi-annual interest payments.

2. Tax-efficient interest

Eligible interest income is exempt from income tax. This may be relevant for investors in higher tax brackets.

3. Relatively high credit quality

Many tax-free bonds are issued by government-backed institutions and public sector undertakings.

4. Secondary-market access

Listed bonds can be bought and sold through the stock exchange, subject to market liquidity.

5. Portfolio diversification

These bonds can help investors spread their investments across different asset classes.

6. Defined maturity value

When held until maturity, the investor receives the face value, provided the issuer meets its repayment obligations.
 

Tax-free bonds can provide long-term fixed interest income that is exempt from income tax under the applicable provisions of Section 10(15). However, investors should not consider them entirely risk-free.
Bond prices may fluctuate, liquidity may be limited, and the issuer’s credit quality can change. Before investing, assess the coupon rate, yield to maturity, credit rating, maturity period, market price, tax treatment, and alignment with your financial goals.