Tax Free Bonds – An Excellent Investment Option

Tax freeFinally India’s bond market is having a sigh of relief where retail investors are getting multiple opportunities to invest in quality bond instruments. To have a basic understanding of bonds, you may intially want to read our article Making Money Out of Bonds. One of the nearest competitors to bonds is fixed deposits which generally finds a home in most of the investor’s portfolio. While, the investors whose income is less than the minimum tax slab of Rs. 2 lacs may not feel the pinch of their FD returns being eaten by the tax man, all other investors loose heavily on their Fixed deposit returns to the tune of their respective maximum tax slab. The desire to have low risk tax free returns finally concludes to Tax Free bonds.


What is a tax free bond ?

Essentially there is no difference between a tax free bond and a normal taxable bond except that the interest on tax free bond is not taxable. Some of the salient features of tax free bonds are :

  1. They are generally issued by infrastructure companies of good credit quality – mostly public sector units.
  2. The bonds are available for maturity duration of 10, 15 and 20 years with annual interest payout.
  3. Can be issued in dematerialised form and in physical form.
  4. Retail investors (investing upto Rs. 10 lacs) get a preferential interest on 20 years maturity duration. – [Thank you Bhushan for pointing this out.]


How much return to expect ?

The return quoted on tax free bonds at the time of their issuance is based upon the ten year Government of India’s bond. Since the current 10 year GSEC rate is hovering around 9%, the bonds are also made available at closer to 9% interest mark. While each of the tax free bond issuance may have slightly different interest rates, most of the current issues have been providing the following interest rates :

  • 10 year maturity – 8.26%
  • 15 years maturity – 8.63%
  • 20 years maturity – 8.76%

Retail investors investing upto Rs. 5 lacs get additional 0.25% interest at the time of initial issue making the returns at 8.51, 8.88 and 9.01% for 10, 15 and 20 years respectively.

Assuming that an investor is investing INR 100,000 for 20 years, we have prepared a comparative pre-tax returns based upon different tax slabs :

Maturity Interest on Bond

10% Slab

20% Slab

30% Slab

10 year





15 year





20 year






Non Residents can also Invest

NRIs can invest in these bonds on a non-repatriable basis only (terms vary from one issue to another). An important consideration for NRIs is the tax implications in their respective resident country. For example, while NRIs in middle east may not need to pay tax on the tax free income from these bonds, NRIs from other countries may need to pay tax on the tax free income in their resident country.


Other Tax free options

BFA TaxWe think that that the tax free bonds can also be compared with other options available in the market. Amongst the other popular tax free options are :

1. PPF – You can read more about PPF on our article Public Provident Fund (PPF). Interest on PPF is fixed on an annual basis and is currently at 8.7%. It is worth mentioning that interest on PPF is continously on a decline from past several years. Also, PPF does not offer liquidity options to the investors till it matures (after 15 years).

2. EPF or Provident Fund – You can refer to our article Provident Fund (PF) – Best Investment Option Available for Salaried Employee !. This option is available only to salaried employees.

3. NRE FDs – We have a detailed article on NRE Fixed Deposit – Should you invest in it ?. Unfortunately this option is available to NRIs only.

While each of these options are individually good, tax free bonds compliments the available population of low risk tax free income option. The additional benefit which these bonds offer over the above instruments are :

  • Against NRE deposits – NRE FDs offer investment option for durations upto 10 years (compared to upto 20 years in tax free bonds)
  • PPF and PF have been subject to continuous downtrend in the interest rate offered by government (tax free bonds offer fixed interest rate for upto 20 year duration).


Secondary market for Liquidity

Tax free bonds are listed on the stock markets to provide an exit option to the investors. For an investor who invested in a 20 year duration bond, this option comes up as a great blessing providing much required liquidity in periods of financial stress.


Which Duration Should Investors Choose ?

Out of 10, 15 and 20 years investment option, investors are most likely to choose the 10 year option. Perhaps 20 years is considered too long a period to invest for most of the investors as they are neither certain of the financial health of the bond issuing company nor of their own financial life. However, in taking this decision, the investors do not consider three important  features of these bonds :

a) These bonds are offered by companies of high credibility

b) The bonds are listed on stock exchange to allow investors to liquidate them when needed.

c) In order to compensate with the uncertainty associated with longer duration maturities, the bonds offer higher interest rates.

Looking into these three options, it makes most sense to invest into the 20 year duration to lock in the rates for long term duration. When needed, investors can exit via the stock market route.


Making it Even Better

So far it was successful only with NRIs where interest earned on their NRE fixed deposits could be invested into Equity mutual funds via monthly SIPs. This was possible as no TDS was deducted on interest on NRE FDs can hence 100% of the interest could be diverted into Equity markets to generate higher returns without adding risk to the overall capital of the investor.

Residents could not find a suitable channel to do this as interest was not only taxable for them, but also got subject to TDS.  However with tax free bonds investors can divert 100% of the interest earned on these bonds into Equity mutual funds via SIPs.  This will allow creation of a tax efficient investment vehicle whereby their capital will be invested in a low risk bond and the interest could be further invested towards high risk equity SIPs.

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7 Replies to “Tax Free Bonds – An Excellent Investment Option”

  1. Two corrections:
    1 – Investors investing upto 10 lakh (not 5 lakh) are classified as retail investors and they get the additional interest
    2 – Allowing NRIs to invest depends on the bonds. For ex: NHB has not allowed NRIs while IRFC has allowed.

  2. Thanks Bhushan. I have made the changes in the article.

  3. what is the upper limit of tax free bond? Can i invest i crore in 10 year in tax free bonds

  4. Munit there is no upper limit for investing into Tax free bonds. If you invest as a part of the initial offer, then you can get preferential interest rates on amounts upto Rs. 10 lacs investments (as a retailers investor). Beyond 10 lacs there is a uniform interest rate and no cap on the max amount which can be invested.

  5. One more correction.

    I doubt if the clarificatipon given above to Munit is correct. If we read the prospectus of NHB or IIFCL 2014 bond issues, it says that if on the record date for interest payment, the aggregate holding of a “retail” invstor exceeds Rs. 10 lakh (face value of bonds), then the higher interest payable to the retail investorss will NOT apply for the ENTIRE investment, which will then attarct the lower interest rate applicable to non-retail investors. Thus, a “retail” investror with more than 10 lakh investment in a isuing entity’s bonds , will NOT be paid interest at two different rates, as you suggest above (higher rate upto 10 lakh, and lower rate beyond 10 lakh invested). Instead, his entire investment will attract only lower interest rate as payable to institutional investors.


  6. Anil
    Thanks for your clarification. I stand corrected. I think my response to Munit was more targetted towards the max amount you can invest in Tax Free bonds and that upto 10 lacs you get preferential rates of retail investors.

  7. Anil
    Thanks for your clarification. I stand corrected. I think my response to Munit was more targetted towards the max amount you can invest in Tax Free bonds and that upto 10 lacs you get preferential rates.

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