Tax-Free Bonds

Tax-free bonds are debt instruments issued by government-owned entities where the interest income earned is completely exempt from income tax. They were issued in large public tranches between 2012 and 2016 by entities like NHAI, HUDCO, PFC, REC, IRFC, and NTPC to fund infrastructure projects. Though no fresh tax-free bonds are currently being issued, the existing ones are available in the secondary market.

What Are Tax-Free Bonds?

Tax-free bonds provide interest income that is exempt under Section 10(15)(iv) of the Income Tax Act. This makes them especially attractive for investors in the higher tax brackets (30% slab) because their post-tax yield is equivalent to a much higher pre-tax yield.

For example, a 8.1% tax-free bond is equivalent to a 11.57% pre-tax FD for someone in the 30% tax bracket.

Issuers of Tax-Free Bonds

Government entities that issued tax-free bonds include:
– NHAI (National Highways Authority of India)
– HUDCO (Housing and Urban Development Corporation)
– PFC (Power Finance Corporation)
– REC (Rural Electrification Corporation)
– IRFC (Indian Railway Finance Corporation)
– NTPC (National Thermal Power Corporation)
– NABARD (National Bank for Agriculture and Rural Development)

Key Features

– **Interest**: fully exempt from income tax
– **Tenure**: typically 10, 15, or 20 years
– **Credit rating**: AAA for most issuers (government ownership)
– **Tradeable**: listed on BSE and NSE; can be bought and sold in secondary market
– **Minimum face value**: Rs 1,000 per bond
– **Interest payment**: annual

How to Buy in Secondary Market

Tax-free bonds trade on BSE and NSE under the bond segment. You need a demat account and a trading account. The yield depends on the current market price relative to the coupon. Buying at a discount (below face value) increases effective yield; buying at a premium reduces it.

Tax on Capital Gains

While interest is tax-free, capital gains from selling the bond in the secondary market are taxable:
– Short-term gains (under 1 year): slab rate
– Long-term gains (over 1 year): 10% without indexation

Practical Example

Ajay, in the 30% tax bracket, buys NHAI tax-free bonds from the secondary market at Rs 1,050 (face value Rs 1,000) with a 8.1% coupon. His yield to maturity is approximately 7.7% (adjusting for premium paid and maturity). Post-tax equivalent for a 30% taxpayer is approximately 11%. His bank offers an FD at 7%, giving a post-tax return of 4.9%. The tax-free bond delivers much better post-tax income.

Key Takeaways

– Tax-free bonds offer interest income completely exempt from income tax
– Equivalent pre-tax yield is much higher than the coupon rate for high-bracket taxpayers
– Available in the secondary market on BSE and NSE; requires demat account
– Capital gains on sale are taxable; only the interest is exempt
– Issued by AAA-rated government entities making them very safe fixed income instruments