What Are Tax-Free Bonds?

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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. 

What are Tax-Free Bonds in India? 

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. 

Examples of Tax-Free Bonds in India 

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 RateInterest Payment FrequencyBond RatingMaturity DateYield to Maturity (YTM)
8.20% Housing and Urban Development Corporation Limited 20278.20%AnnualCARE AAA StableMarch 5, 20275.08%
7.39% Housing and Urban Development Corporation Limited 20317.39%AnnualCARE AAA StableFebruary 8, 20315.25%
7.38% Rural Electrification Corporation Limited 20277.38%AnnualCARE AAA StableDecember 19. 20275.14%

Key Features and Benefits of Tax-Free Bonds 

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.

  • Attractive Coupon Rates

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. 

  • Annual Interest Payouts

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. 

  • Tax Exemption 

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. 

  • Long-Term Investment Outlook

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. 

  • Tradeability

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

  • Flexibility of Bond Holdings

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. 

Tax-Free Bonds vs. Tax-Saving Bonds

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. 

How to Invest in Tax-Free Bonds in India?

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. 


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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