BAJAJ BROKING
September 09, 2023
14 mins read
One of the most important aspects to look into before you choose an investment option is the returns it can deliver. At first glance, the returns from one investment may seem to surpass the returns from another. However, if you only compare gross returns, you may be at a disadvantage. What you really need to look at is the post-tax return rate. Some investments that offer tax free returns or tax exemptions may be better in this regard. Tax-free bonds in India are a prime example of this type of investment. If you want to earn tax-free returns or benefit from other kinds of tax savings, you can consider adding these bonds to your portfolio.
Before you do this, however, it’s crucial to understand what tax-free bonds are, their key features, how to apply for tax-free bonds and the other finer details of these securities.
Tax-free bonds are a popular investment choice for individuals seeking stable returns while minimising their tax liability. These bonds, primarily issued by government-backed entities, offer tax-free interest income, making them an attractive option for long-term investors. Since they are backed by the government, they come with low risk, ensuring capital safety and predictable returns.
In this guide, we will explore the features of tax-free bonds, their benefits, risks, and how investors can purchase them. Understanding the investment process and tax advantages can help investors make informed financial decisions while maximising returns.
Tax-free bonds are fixed-income securities issued by government-backed entities where the interest earned is exempt from income tax under Section 10(15) of the Income Tax Act. These bonds are primarily used to fund public infrastructure projects such as roads, railways, and power generation.
Investors receive annual or semi-annual interest payments without worrying about taxation, making these bonds ideal for individuals in higher tax brackets. Since the principal amount is repaid at maturity, tax-free bonds provide long-term financial security with minimal risk exposure.
Tax-free bonds have distinct features that make them a preferred choice for conservative investors seeking stable returns with tax advantages.
1. Low Risk
Since tax-free bonds are issued by government-backed entities, they are considered one of the safest investment options. The risk of default is minimal as the issuing organisations have strong financial backing. Investors looking for capital protection and steady income prefer these bonds over riskier market-linked instruments.
2. Long-Term Investment
These bonds typically have a tenure of 10 to 20 years, making them suitable for long-term financial planning. Investors seeking stable, tax-free income over an extended period can benefit from their predictable interest payments. While they can be sold in the secondary market, liquidity is lower compared to equity investments.
3. Fixed Interest Payments
Tax-free bonds pay fixed interest annually or semi-annually, providing a regular source of income. The interest rates are determined at the time of issuance and remain unchanged throughout the bond’s tenure. This ensures predictability, making them ideal for retirees or individuals seeking consistent cash flow.
4. No Tax Deduction at Source (TDS)
Unlike fixed deposits and other taxable investments, tax-free bonds do not attract TDS on interest payments. Investors receive the full interest amount without deductions, simplifying the tax reporting process and maximising earnings.
5. Listed on Stock Exchanges
Although tax-free bonds are long-term instruments, they are listed on stock exchanges, allowing investors to trade them in the secondary market. This provides liquidity for investors who wish to exit before maturity. However, secondary market prices fluctuate based on demand, interest rate movements, and economic conditions.
Tax-free bonds are primarily issued by government-owned institutions for financing infrastructure and development projects. Here are some of the major types of tax-free bonds available in India:
1. National Highways Authority of India (NHAI) Bonds
These bonds are issued to fund road and highway infrastructure projects across India. Backed by the central government, they offer low-risk investment opportunities with stable returns and tax-free interest income.
2. Indian Railways Finance Corporation (IRFC) Bonds
IRFC issues tax-free bonds to finance the development of railway infrastructure. Investors in these bonds contribute to railway expansion while earning stable, tax-free returns with minimal risk.
3. Power Finance Corporation (PFC) Bonds
PFC issues tax-free bonds to fund electricity and power sector projects. These bonds provide a steady return, making them attractive for investors looking for safe and tax-efficient income sources.
4. Rural Electrification Corporation (REC) Bonds
These bonds finance rural electrification projects, supporting energy distribution in remote areas. They are backed by the government, ensuring financial security for investors while providing tax-free interest earnings.
Investing in tax-free bonds is straightforward and can be done through primary or secondary markets. Here’s a step-by-step guide on how to invest in tax-free bonds:
1. Primary Market Investment
Investors can purchase tax-free bonds when they are initially issued by government institutions. These bonds are available through stock exchanges, designated banks, and financial institutions. The application process involves submitting a form during the public issue period and making the payment via net banking or cheque.
2. Secondary Market Investment
If an investor misses the initial issuance, tax-free bonds can be purchased from the secondary market through stock exchanges. Investors need a Demat account and a trading account to buy these bonds. Prices fluctuate based on interest rates, demand, and economic conditions, offering opportunities for capital appreciation.
3. Trading and Liquidity
While tax-free bonds are long-term instruments, they can be sold on the stock exchange before maturity. However, liquidity is lower compared to stocks and mutual funds. Investors should check market conditions before selling, as bond prices are influenced by prevailing interest rates and investor demand.
4. Documentation and KYC
Investors need to complete Know Your Customer (KYC) formalities, including PAN card submission, identity proof, and address verification. These documents are required for purchasing bonds, whether through the primary or secondary market.
Tax-free bonds are debt securities that offer tax-exempt interest payments. To understand this unique benefit, let’s take a closer look at how regular taxable bonds work. These bonds are debt instruments that offer annual coupon payments — also known as interest payments — to investors.
For example, if you invest Rs. 1 lakh in a 7% bond, you will earn Rs. 7,000 as interest per annum. This interest is added to your total income and taxed at the income tax slab rate applicable to you. So, if the 30% tax slab is applicable to you, your coupon payments will also be taxed at this rate.
In the case of tax-free bonds, however, the interest is exempt from tax. So, you can earn the annual coupon payments without worrying about increasing your tax burden on account of the additional income. Typically, these bonds are issued by government-backed companies like the Power Finance Corporation, Indian Railways Finance Corporation Limited, NTPC Limited, National Highways Authority of India and the Rural Electrification Corporation.
Issued by government-backed entities, infrastructure bonds finance large projects like highways and bridges. They provide tax-free income and attract investors interested in supporting national development.
Housing bonds are issued by the National Housing Bank to fund affordable housing projects. They offer tax-exempt interest and contribute to making home ownership more accessible.
Typically issued by power generation companies, power bonds support the expansion of power plants. Investors earn tax-free returns while enhancing the country's energy capacity.
Issued by Indian Railways, these bonds finance railway modernization. They provide tax-free income and are popular among those seeking long-term investment opportunities.
These bonds are issued by government-owned enterprises to fund various initiatives. They are low-risk investments offering tax-exempt interest, making them attractive for stable financial growth.
Tax free bonds are fixed-income securities issued by government-backed entities to finance infrastructure projects. When investors purchase these bonds, they effectively lend money to the issuer, receiving regular interest payments that are exempt from income tax. This feature makes them particularly appealing for those looking to reduce their tax on bonds in india. The principal amount is typically returned at maturity, which usually ranges from 10 to 15 years, providing a reliable income stream.
These bonds are listed on stock exchanges, offering liquidity and the option to buy or sell before maturity. Due to their govt tax free bonds status, these investments often experience high demand, especially during tax planning periods. Investors can benefit from the combination of secure capital and tax-free returns, making them a key component of many tax saving bonds strategies.
Pros | Cons |
Tax Exemption: Interest earned is exempt from income tax, making these bonds an attractive option for individuals looking to reduce their tax burden. | Lower Returns: Compared to some other investment options, tax-free bonds may offer lower interest rates, potentially resulting in lower overall returns. |
Low Risk: Issued by government-backed entities, these bonds are considered low-risk investments, providing security to investors. | Long-Term Commitment: Tax-free bonds typically have longer maturities, ranging from 10 to 15 years, which may not suit investors looking for short-term liquidity. |
Stable Income: Investors receive regular interest payments, ensuring a predictable cash flow over time. | Market Risk: While generally stable, the market value of these bonds can fluctuate based on interest rate changes, affecting their liquidity. |
Diversification: Tax-free bonds can help diversify an investment portfolio, spreading risk across different asset classes. | Investment Minimums: Some tax-free bonds may have high minimum investment amounts, which could limit access for smaller investors. |
Now that you know what tax-free bonds in India are, let’s take a closer look at some examples of these securities, so you can get more clarity on their characteristics.
| Bond | Coupon Rate | Interest Payment Frequency | Bond Rating | Maturity Date | Yield to Maturity (YTM) |
| 8.20% Housing and Urban Development Corporation Limited 2027 | 8.20% | Annual | CARE AAA Stable | March 5, 2027 | 5.08% |
| 7.39% Housing and Urban Development Corporation Limited 2031 | 7.39% | Annual | CARE AAA Stable | February 8, 2031 | 5.25% |
| 7.38% Rural Electrification Corporation Limited 2027 | 7.38% | Annual | CARE AAA Stable | December 19. 2027 | 5.14% |
Tax-free bonds in India have several distinct features that can be beneficial to you if you choose to invest in them. Here is a closer look at these features.
Tax-free bonds in India offer attractive interest rates over and above the tax benefits. The interest rates can exceed 7% per annum, which, when combined with the tax exemption, can be an attractive financial proposition for investors. The post-tax returns on these tax-free bonds are essentially the coupon rates, so you can compare the interest rates with the post-tax returns from other assets to get more clarity.
Tax-free bonds typically offer annual coupon payments paid out once each year. While this may not be as regular as monthly payouts, they can still be handy in different ways. Since you know with certainty that you will receive this specific sum each year, you can plan your insurance payments or tax payments accordingly and use the coupon payment to meet these recurring annual expenses.
This is, of course, the most defining feature of tax-free bonds in India. The annual coupon payments you receive from these securities are not taxable. In addition to this, there is also no limit on the maximum amount of interest that can be tax-free. So, your entire income in this category will be exempt, making it a highly lucrative investment avenue if you want to enjoy the dual benefits of reduced tax burden and steady income.
Since tax-free bonds offer the added benefit of tax savings, the maturity period is generally several years. This means your capital will typically be locked in during the entire tenure. Before you invest in tax-free bonds in India, you need to keep this aspect in mind and ensure that you are comfortable with having your funds tied up. It is advisable to avoid investing money you need over the short term in these long-term bonds.
Tax-free bonds may not be as liquid as some other kinds of bonds. However, if you do successfully trade them on the market exchanges, the profit that you earn from the sale will be taxable as long-term capital gains (LTCG) or short-term capital gains (STCG). The tax exemption benefit is only on the coupon payments you receive from the bond.
Also Read: Long-Term Capital Gain Tax on Property Explained
Another feature of tax-free bonds in India is the flexibility in holdings. You can hold them in the physical format or the electronic format. For the latter, you will require a demat account. However, it is generally advisable to hold your tax-free bonds in the electronic format since they are easier to transform or redeem this way.
While tax-free bonds offer tax exemption on the coupon payments received, there are other kinds of bonds that offer different tax benefits. These are tax-saving bonds, and the amount you invest in these securities is deductible from your total income, thereby reducing your total taxable income and the resulting tax liability.
This tax-saving benefit stems from section 80CCF of the Income Tax Act, 1961. You can claim a maximum deduction of Rs. 20,000 during the financial year in which you make the investment. However, keep in mind that for these bonds, the interest is not tax free. Only the principal investment is deductible.
Want to know how to apply for tax free bonds in India? The first step is to open a demat account if you want to buy these bonds electronically. Then, you can either purchase tax free bonds in the primary market during a new issue, or you can choose to buy them in the secondary market if they are trading in that segment.
Even if you opt to buy these bonds in the physical format, it is mandatory to submit the details of your PAN and complete the Know Your Customer (KYC) procedures.
Government Agencies: Various government bodies issue tax-free bonds to fund infrastructure projects, enhancing public facilities and services.
Public Sector Undertakings (PSUs): Organizations like the Power Finance Corporation and National Highway Authority of India issue these bonds for development and maintenance projects.
Municipal Corporations: Local government entities often issue tax-free bonds to raise funds for urban infrastructure and housing projects.
Infrastructure Companies: Private firms engaged in large-scale infrastructure projects also issue tax-free bonds, typically backed by government guarantees.
Financial Institutions: Some banks and non-banking financial companies (NBFCs) issue tax-free bonds to attract investments for various projects.
Tax-free bonds offer a secure and tax-efficient way to earn stable returns over the long term. Backed by government-owned institutions, they provide low-risk investment opportunities with predictable interest payments. While they may have limited liquidity and lower yields than taxable bonds, their tax-free nature makes them highly attractive for investors in high tax brackets.
For individuals seeking steady income, capital preservation, and tax efficiency, tax-free bonds remain an excellent addition to a diversified investment portfolio. Whether buying through primary issues or secondary markets, understanding their features and risks is essential for maximising returns.
So, now that you know what tax-free bonds in India are and how they work, you can integrate these debt instruments into your tax planning strategy. If you wish to earn tax benefits on the coupon payments, tax-free bonds are ideal. However, if you want tax deductions on the principal invested, tax-saving bonds are suitable.
What’s more, you can also include both these types of bonds in your portfolio to maximise your tax benefits and reduce your tax burden while earning steady income in the process.
Additional Read: What Are Corporate Bonds?
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Tax free bonds are issued by government entities and public sector undertakings (PSUs). The interest earned on these bonds is exempt from income tax, making them a popular choice for investors seeking to reduce their overall tax liabilities.
The Reserve Bank of India (RBI) does not directly issue tax free bonds. However, it plays a regulatory role for those bonds issued by government-backed entities and financial institutions, ensuring they comply with relevant regulations.
Yes, bonds issued by the National Highways Authority of India (NHAI) are classified as govt tax free bonds. These bonds provide tax-exempt interest to investors, which makes them an attractive option for long-term investment in infrastructure.
Interest rates on Indian Railway Finance Corporation (IRFC) tax-free bonds typically range from 5.5% to 7.5%, depending on market conditions. These rates are competitive among tax free government bonds, appealing to investors looking for steady returns.
Articles on taxation of bonds outline the treatment of interest income from bonds under the Income Tax Act. This includes detailed explanations of how tax free bonds are taxed and the implications for investors.
Tax free bonds provide tax-exempt interest income, while regular bonds often have taxable interest. This key difference can significantly affect an investor's net returns and overall tax strategy, making tax-free bonds more attractive for tax-conscious investors.
Yes, investors have the option to sell tax free bonds on stock exchanges before their maturity dates. This feature offers liquidity, allowing investors to access their funds without having to wait for the bond to mature.
While generally considered low-risk investments, tax saving bonds carry certain risks such as interest rate fluctuations and market volatility. Investors should assess these risks in light of their financial goals and risk tolerance.
Eligibility for investing in tax free bonds india typically includes individuals, Hindu Undivided Families (HUFs), and Non-Resident Indians (NRIs). This broad accessibility makes them a versatile investment option for many types of investors.
Investors can find tax free government securities by browsing stock exchanges, consulting financial advisors, or researching online platforms that provide detailed information on available bonds and their features.
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