What are tax-free bonds?

Last Updated: 24 Jan 2025

Tax-Free Bonds

Fixed income securities are everyone’s favourite while safe capital investing is the first preference. Although, they offer lower returns as compared to equity and other risky investment options. Additionally, the return cuts down more due to tax liability levied on it. There comes one fixed-income instrument where the tax liability is negligible, and that is tax-free bond.

This article spotlights tax-free bonds’ meaning, their key advantages, and how they work.

What are tax-free bonds?

Tax-free bonds are those fixed-income securities issued by public undertakings which offer tax-free interest income to the Investors The investors earn the pre-fixed interest each year, without incurring any tax obligations on it. Similar to other bonds, they also repay the principal amount on maturity.

Generally, the tax-free bonds in India are issued at a face value. of Rs. 1000. After its issuance, they may trade at discount i.e. at a value lesser than Rs. 1000, or at premium i.e. at a higher value than Rs. 1000 in the secondary market. However, the gain from selling the bonds in the secondary market would attract capital gain tax.

Investors can opt to trade these bonds through a Demat account or physical form. One can apply for these government bonds via online or offline routes. Moreover, the bond issuer cannot repurchase the bond from the secondary market.

The interest rate is fixed based on face value. Even if the price of a bond varies in the secondary market, the interest amount remains the same. For instance, a government enterprise issues a bond at Rs. 1000 with a coupon rate of 8.5%, and after two months of the closing of issuance, the bond is trading at Rs. 1060, the interest income would still be Rs. 85 and not Rs. 90 (8.5% of 1060). The higher the price, the lower would be the return and vice versa. Tenure is also an important factor when investing in tax-free bonds.

If a bondholder chooses to keep the bond till maturity, he/she can redeem these bonds and get repaid the entire principal amount at maturity.

Some of the tax-free bonds in India are the bonds issued by Power Finance Corporation, NTPC Limited, Indian Railways Finance Corporation Limited, Rural Electrification Corporation, National Highways Authority of India, etc.

What are the advantages of the tax-free bond?

One of the key benefits of tax-free bonds is the higher safety of the investment. Since they are issued and backed by government entities, the probability of default of interest payment and principal repayment is pretty low. Despite the minimum risk, the yield offered by such bonds is relatively higher.

Additionally, the interest earned from a tax-free bond is free from tax liability. Neither the tax deducted at source (TDS) applies to these bonds. For the investors who belong to high tax slabs, these bonds are a more suitable investment avenue than other taxable investment options.

Moreover, if a bondholder is willing to liquidate the investment, investors can sell the tax-free bonds in the secondary market through an exchange. An investor can also take a benefit by trading it when the market prices are higher.

How do tax-free bonds work?

The tax-free bonds are issued by those government entities that want to raise funds for certain capital expenditures. The issue remains open for a short period. Investors can subscribe to the issue to purchase these bonds.

Similar to other bonds, these bonds also offer fixed interest as a return for investors. The interest rate is determined based on the prevailing yield on government securities when they are issued, the credit ratings of the issuer, and the qualification of investors i.e. whether they are retail investors or high net worth individuals (HNIs). The investors who invest up to Rs. 10 lakh in an issue, are considered retail investors, whereas the investors investing more than Rs. 10 lakh for an issue are qualified as HNIs.

The tax-free bonds usually come with a long tenure of 10, 15, or 20 years. The bondholders can redeem their tax-free bonds at maturity. Investors can also buy and sell these bonds, post-issuance and before maturity, in the secondary market. If the bondholder sells the bond before one year, their profit is taxable as per the income tax slab. If the bondholder sells it after one year, their profit will be levied a long-term capital gain tax of 10%, without any price adjustment benefits.

To wrap up, tax-free bonds keep the investors free from the tax obligations on interest income earned on them. They provide good returns while minimizing the risk. Though, the liquidity of such bonds is lower due to their long tenure. However, the tax-free bonds are more suitable for those investors who prefer less risk and are willing to stay invested for a longer term.

What are the common types of tax-free bonds?

Tax-free bonds are a popular investment option, offering stable returns and tax benefits. What are tax-free bonds? They are issued by government-backed entities and come in various types, such as:

1. Infrastructure Bonds: These bonds fund significant infrastructure projects such as roads, airports, and seaports. They aim to boost the country’s infrastructure and attract substantial investment.
2. Housing Bonds: Issued to support affordable housing schemes, these bonds help in raising funds for constructing homes for economically weaker sections and low-income groups.
3. Power Bonds: These bonds finance projects related to power generation, transmission, and distribution. They are crucial for improving the country’s power infrastructure.
4. Railway Bonds: Issued by entities like the Indian Railways Finance Corporation (IRFC), these bonds are used to improve and expand railway infrastructure.
5. Public Sector Unit (PSU) Bonds: Issued by government-owned companies, these bonds raise funds for various public sector projects and operations.

Tax-free bonds advantage individuals by providing regular interest income exempt from income tax, making them an attractive option for risk-averse investors seeking steady returns. Tax-free bonds benefit these investors as they promote them to be bold in making their investment choices.

Features of tax-free bonds

Being a risky investment, there should be something that pulls individuals towards investing. One such characteristic is tax-free bonds. Tax-free bonds offer numerous features that make them attractive to investors. Here is a list of advantages investors can avail by understanding how tax-free bonds work :

• Tax Benefits: One of the main attractions is the tax exemption on the interest earned, under Section 10(15) of the Income Tax Act. Understanding what are tax-free bonds can help investors maximize their returns while benefiting from tax savings.
• Long Maturity Periods: Typically, these bonds have maturity periods ranging from 10 to 20 years, making them suitable for long-term investment strategies.
• Low Risk: Issued by government entities, these bonds carry minimal risk, making them a secure investment option for risk-averse investors.
• Fixed Interest Rates: They offer fixed interest rates, providing predictable returns over the investment period. This feature is particularly beneficial for investors seeking steady income.
• Liquidity: These bonds are tradable on stock exchanges, offering liquidity to investors who may need to exit their positions before maturity. This feature enhances the flexibility and appeal of tax-free bonds.
• Regular Income: They provide periodic interest payments, which can be beneficial for income-seeking investors. This regular income is particularly advantageous for retirees or individuals looking for a steady cash flow.
• Support for Government Projects: Investing in these bonds supports the funding of essential government projects, contributing to national development.

Understanding the features of tax-free bonds can help investors make informed decisions. This also ensures their investment portfolio is well aligned with their financial goals and risk tolerance.

What are the advantages of the tax-free bond?

Here are a few advantages one could avail from tax-free bonds:-

1. Tax-Free Interest Income
2. Low Risk
3. Predictable Returns
4. Long-Term Investment
5. Easy Liquidity
6. Support Government Projects

Who issues tax-free bonds?

Tax-free bonds are issued by government entities and public sector undertakings to finance development projects. Common issuers include:

1. National Highways Authority of India (NHAI): These bonds fund road infrastructure projects.
2. Power Finance Corporation (PFC): Issued to finance power generation and distribution projects.
3. Housing and Urban Development Corporation (HUDCO): Supports affordable housing initiatives.
4. Indian Railways Finance Corporation (IRFC): Funds railway infrastructure projects.
5. Rural Electrification Corporation (REC): Finances rural electrification projects.

These issuers ensure that the funds raised are used for essential infrastructure and development projects, providing investors with a safe investment option that supports the country’s growth.

Frequently Asked Questions

1. How to redeem your tax-free bonds?

You can redeem your tax-free bonds at maturity. Before maturity, you can sell the bond to other investors in the secondary market. Your capital gain is taxable under Section 112. If you sell the bond before one year, your profit is taxable as per the income tax slab. If you sell it after one year, your profit will be levied a long-term capital gain tax of 10%, without any price adjustment benefits.

2. Which government bonds are tax-free?

The bonds issued by the state, city, and local governments, for example, municipal bonds, for raising funds for a specific purpose are tax-free. Some of the common tax-free bonds are the bonds issued by Power Finance Corporation, NTPC Limited, Indian Railways Finance Corporation Limited, etc.

How can one invest in tax-free bonds?

Individuals looking to invest in tax-free bonds require a Demat account. Purchases can be made through primary or secondary markets. Investors can participate in public issues or buy from stock exchanges.

Why invest in tax-free bonds?

Investing in tax-free bonds provides tax-free interest income, safety, and predictable returns. This makes them an attractive option for individuals looking for risk-averse investment opportunities, seeking steady income and portfolio diversification.

How do you redeem tax-free bonds?

Tax-free bonds are redeemed upon maturity, where the principal amount is returned to the investor. Investors receive periodic interest payments throughout the bond’s tenure in regular intervals until the bond reaches maturity.