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What are Tax Free Bonds?

Can tax-free bonds be liquidated early if required? How can I buy them?

Kavita Soni

Tax free bonds are the tax free financial instruments issued by select public sector units. Interest earned by investing in these bonds does not form a part of total taxable income irrespective of the income slab of the investor. They are actually the best suited option for investors falling in high tax brackets.

Like other bonds, tax free bonds also have coupon rate of interest and are issued for a fixed period of time. Tenure for these bonds could range from 10 or 15 to 20 years. It is important to note that the interest income is tax exempt and not the amount invested using these bonds.

Tax free bonds are considered to be quasi-government bonds and safe to invest in as they provide stable returns. As other bonds, these bonds are also listed on stock exchanges and can be traded in the secondary market. They provide a high pre-tax yield and are considered in low-risk asset class.

Talking about the working of tax free bonds, their interest rate is devised in accordance with the government securities prevailing at the time of issuance. Rating of the issuer and whether the investor is retail one or one with high net worth helps in deciding the interest rate for these bonds. Interest on these bonds is generally paid on an annual basis.

Tax free bonds are considered to be a useful option for tax reduction in short period but if one is thinking about long term investment benefits, then there are better options available in the funds market.


A bond is a fixed income instrument carrying a coupon rate of interest for a fixed tenure. For example: If bond is issued at Rs 100 at a coupon rate of interest of 10% p.a. then the investor gets Rs 10 at the end of every year for 4 years and Rs 110 at the end of 5th year (Principal + interest income at the end of 5th year). 

  • Tax free bonds as the name suggests are bonds in which the interest income earned is not taxed.
  • The interest earned from these bonds does not form part of the total income, and so no income tax is accrued on it. Note: there is tax deduction on the invested amount.
  • Interest returns on these bond are generally annual.
  • These are low risk investments and are issued by government enterprises such as NHAI, IRFC, PFC, HUDCO, REC, NTPC, etc.
  • The raised funds are utilised for infrastructure projects.
  • These bonds have a long term maturity of 10,15 or 20 years and provide greater returns as compared to fixed deposits as the income earned is not taxed.
  • The bonds are listed on stock exchanges and can be traded only through demat account.

Can tax free bonds be liquidated early if required?

  • Tax free bonds cannot be sold back to the issuing authority. However, they can be traded in the secondary market.
  • If the holding period of these bonds is less than 12 months, capital gains on sale of these bonds on stock exchanges are taxed as per the tax rate of the investor. If bonds are held for more than 12 months and then sold, capital gains are taxed at 10 percent without adjusting for inflation, or 20 percent with inflation adjustment, whichever is lower.

These investments are good for individuals who can afford to park their wealth for a long time.


1.      Tax-free bonds are issued by government organizations and pay a fixed rate of interests.

2.     These bonds are of long-term maturity and the proceeds are usually invested in infrastructure projects.

3.     The income that you earn in the form of interests is fully exempted from income tax act. However, the amount you invest in buying the bonds is not eligible for any tax deduction.

4.     The interest amount earned on tax-free bonds is credited directly to the bond holder’s bank account. And since these are government backed securities, there is no credit or default risk attached to it.

5.     So, if you are looking for a stable source of income, tax-free bonds are the best investment option for you.

6.     One can also trade using these bonds. However, any capital gain from the sale of these bonds in the secondary market is taxable.

7.     Some of the public undertakings which raise funds through the issue of tax-free bonds are IRFC, PFC, NHAI, HUDCO, REC, NTPC, and Indian Renewable Energy Development Agency.

8.     The tenure of the bonds is usually 10/15 or even 20 years. They are also listed on stock exchanges to offer an exit route to investors. The bonds are tax-free, secured, redeemable and non-convertible in nature.

9.     Working: The interest that an issuer can offer to investors depends on the yield of government securities prevailing around the time of issuance. Once set and offered, it will remain fixed for the entire tenure. The interest rate will depend on two factors - One, on the ratings of the issuer and secondly, whether the investor is a retail or a high net worth investor.

For tax-free bonds rated AAA, the interest rate for retail investors will be 0.5 per cent lower than the G-sec rate and 0.8 per cent lower for all other investors. For tax-free bonds rated AA+, the interest rate will be 0.10 per cent higher than AAA-rated issuers and for tax-free bonds rated AA or AA-, the interest rate will be 0.20 per cent higher than AAA-rated issuers.

Retail individual investor is one who is investing up to Rs 10 lakh in each issue, including NRI's (on repatriation or non-repatriation basis), while those investing above Rs 10 lakh are considered high net worth individuals.

 Conclusion: Tax-free bonds may not be ideal to create wealth in order to meet long-term goals such as child education, marriage or retirement. They primarily help one to keep one's tax liability at bay. Therefore, invest in them after properly evaluating your tax rate, tax liability and long-term needs.


A tax free bond is usually issued by a public undertaking and has a fixed interest rate and tenure. Some of such public undertakings are IRFC, NTPC, REC, etc. As the name suggests, the income earned on these bonds is exempt from tax. However, the amount of investment is not exempt from tax. The tenure is usually 10, 15 or 20 years.

These bonds are listed on either BSE or NSE and can be bought or sold from these stock exchanges and can be traded only through a demat account. The interest rate of tax free bonds depends on two factors-

1- Ratings of the issuer

2- Nature of the investor (retail or high worth)

Retail investor refers to a person who is investing upto Rs 10 Lakh in each issue. While a person investing more than Rs 10 Lakh is considered a high net worth individual.

Tax free bonds are very popular amongst high net worth investors because they allow you to put a huge amount of your money at one place, while keeping tax liability at bay. Another plus point of these bonds is that they have minimal credit risk or risk of non-repayment as they are issued by government backed companies.

These tax free bonds have a lock-in period of 10-20 years and hence cannot be sold to the issuing authority. However, they can be sold to another person in the secondary market. Any capital gain from such a sale is taxable. Short term capital gains from the sale of tax free bonds are taxed at the normal tax rate but long term capital gains are taxed at 10% without adjusting for inflation or 20% with inflation adjustment, whichever is lower.

These bonds are especially useful for people who are in the highest tax slab paying 30.9 per cent tax on their income.

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