Summary: Tax-free bonds are issued by government-backed PSUs. The interest income earned is completely tax-exempt, but investors who sell the bonds in the secondary market may be subjected to capital gains tax. This guide explains how the post-tax math works, who these bonds are suited for, and how to buy them in the secondary market in 2026.
Quick Overview
- Tax-free bonds can provide stable returns for investors looking for fixed-income debt investments in 2026
- They are issued by government-backed entities such as NHAI and PFC
- Interest earned is entirely exempt from income tax under Section 10(15)(iv)(h) of the Income Tax Act; capital gains may be applicable in case of selling in the secondary market
- Currently, there are no new primary issues, but they are actively traded in the secondary market
A higher rate of return on an investment does not always mean higher earnings in your pocket. Many fixed-income investments lose a part of their returns to taxes every year, quietly reducing what you actually keep. However, tax-free bonds offer a different path.
They offer predictable income without tax eating into your returns, making them especially attractive if you are looking for stability, efficiency, and long-term income.
This guide explains how tax-free bonds work, who they are best suited for, and how you can still access them today.
What are Tax-free Bonds?
Tax-free bonds are fixed-income securities issued by government-backed organizations for financing national infrastructure.
Public Sector Undertakings (PSUs) issue these long-term debt instruments. These bonds pay you annual interest based on coupon rates, which are exempt from income tax under Section 10(15)(iv)(h) of the Income Tax Act, 1961.
You get your original investment amount back when the bond matures. These bonds usually cannot be redeemed before maturity, but you can sell them in the secondary market if needed.
Tax-free bonds generally offer lower interest rates than many other bonds. However, since the interest earned is exempt from tax, investors often end up with better post-tax returns compared to some taxable bonds offering higher interest rates.
Key Features of Tax-free Bonds
Tax-free bonds come with a few distinct features that make them different from traditional fixed-income investments.
- Absolute tax exemption: Interest earned under Section 10(15)(iv)(h) stays tax-free. In most cases, issuers deduct no TDS
- Long tenures: These bonds have a duration of 10 to 20 years, making them suitable if you are looking for long-term fixed-income investments
- Top credit ratings: Many of these tax-free bonds are issued by government-backed PSUs, and often carry the highest credit ratings, such as ‘AAA/Stable’. However, credit ratings depend on the creditworthiness of the issuer and may vary
- Secondary market liquidity: Bonds can be traded on NSE and BSE platforms just like stocks
Common Issuers of Tax-free Bonds in India
Tax-free bonds are commonly issued by prominent public sector undertakings:
| Issuer | Focus Area |
| National Highways Authority of India (NHAI) | Funds road infrastructure |
| Power Finance Corporation (PFC) | Supports the power sector |
| Rural Electrification Corporation (REC) | Focuses on rural power projects |
| Indian Railway Finance Corporation (IRFC) | Finances railway assets |
| Housing and Urban Development Corporation (HUDCO) | Funds housing initiatives |
Who Should Consider Adding Tax-free Bonds to Their Portfolio?
If you fall in a higher tax bracket, tax-free bonds may help improve post-tax yields. These bonds may also suit conservative portfolios that prioritize stability over equity market volatility, as they are often government-backed and offer predictable returns. For retirees seeking a steady income stream, they can provide fixed returns with tax-exempt interest. HUFs and NRIs are also generally eligible to invest in these instruments.
When tax-free bonds may be relevant:
- High tax bracket: Post-tax yields may outperform some taxable alternatives
- Conservative style: Capital safety goal values stability more than market fluctuations
- Steady income needs: Retiree-friendly
- HUF or NRI: Generally eligible to invest
Comparing tax-free bonds with taxable bonds can show you how different coupon rates can lead to very different post-tax outcomes. You may also include both in your portfolio for diversification.
Benefits and Advantages of Tax-free Bonds
Tax-free bonds appeal to you because they combine predictable income with tax efficiency. Here are some of the key advantages investors should consider:
- Tax-free interest improves effective returns: Interest earned from notified tax-free bonds remains exempt from tax, which can make post-tax returns more attractive for investors in higher tax brackets.
- Stable income supports long-term planning: These bonds provide fixed interest payments at regular intervals, helping you plan predictable cash flows over long holding periods.
- Government-backed issuers improve credit quality: Many tax-free bonds are issued by government-backed PSUs and often carry high credit ratings, reducing default-related concerns compared to lower-rated debt instruments.
Risks and Limitations to Keep in Mind
Tax-free bonds are generally considered stable due to government backing and tax advantages. You should be aware of several limitations before investing in them:
- Liquidity risk is a concern: In tax-exempt bonds, due to low secondary market volumes impeding exits, selling large quantities might necessitate some pricing adjustments. Trading volumes differ greatly among various issuers.
- Bond price depends on interest rate risk: Rising interest rates will lower the market price of bonds, and the market value of already issued bonds declines as newer bonds have higher coupons. Duration also influences this sensitivity.
- Fixed interest payments lose real value: Inflation may reduce real returns if CPI inflation remains above coupon rates over long periods.
Tax Implications on Sale and Redemption
Interest earned from notified tax-free bonds remains exempt from tax under Section 10(15)(iv)(h) of the Income Tax Act. However, any profit earned from selling these bonds in the secondary market is taxable as capital gains.
Here’s how taxation applies when listed tax-free bonds are sold in the secondary market:
- Sold within 12 months: Gains are treated as short-term capital gains (STCG) and taxed as per your applicable income tax slab
- Sold after 12 months: Gains are treated as long-term capital gains (LTCG) and taxed at 12.5% without indexation under Section 112 of the Income Tax Act for transfers made on or after July 23, 2024
If the bonds are held until maturity and redeemed at face value, capital gains tax generally does not arise unless the redemption value differs from the acquisition cost.
Capital gains and capital losses from bond transactions can generally be adjusted against each other based on applicable set-off and carry-forward tax rules.
For NRIs, TDS provisions may apply to capital gains depending on the nature of the transaction and applicable FEMA, RBI, and DTAA regulations. If you are a residential investor, you may not face TDS on capital gains arising from bond sales.
Tax-free Bonds vs. Tax-saving Bonds vs Tax-saving FDs
Tax-free bonds are not the same as tax-saving bonds, which are also known as Section 85 Capital Gain Tax Exemption Bonds (under the new Income Tax Act framework, replacing the erstwhile Section 54EC framework). Tax-savings bonds are intended to legally avoid capital gains on the sale of land or a building, but the interest from those bonds is taxable. Interest income from tax-free bonds is completely exempted from tax.
Tax-saving fixed deposits give you taxable fixed returns until maturity, but the investment qualifies for Section 80C deductions under the old tax regime; the limit is capped at ₹1.5 lakhs. However, those opting for the new tax regime cannot claim tax benefits under 80C.
Tax-free bonds differ significantly from other popular debt instruments in terms of tax treatment and maturity. Here’s a quick comparison:
| Feature | Tax-free Bonds | Tax Saving FDs (80C) | Section 85 (previously Section 54EC) Capital Gains Bonds |
| Tax on Interest | Exempt under Section 10(15) | Taxable at the slab | Taxable at the slab |
| Tenure | 10-20 years | 5 years lock-in | 5 years |
| Interest rate | 6.88% to 8.92% (varies based on bond terms) | 6%-8% (varies based on banks) | Typically 5.25% (may vary based on issuer) |
Let’s explore an example for ease of understanding.
Consider that you are in the 30% tax slab and you are looking to invest ₹1,00,000.
If you invest in a tax-free bond at 6%:
Annual interest = ₹1,00,000 × 6% = ₹6,000 (100% tax-free)
When you invest in a 7.5% Fixed Deposit:
Annual interest = ₹1,00,000 × 7.5% = ₹7,500.
Tax @ 30% = ₹7,500 × 30% = ₹2,250.
Post-tax return = ₹7,500 – ₹2,250 = ₹5,250
Annual difference: A tax-free bond gives ₹750 more per year (₹6,000 vs. ₹5,250 post-tax FD).
In this illustration, the post-tax income from the tax-free bond is higher.
You may compare tax-free bonds with other fixed-income instruments and use platforms like Jiraaf to compare details to make an informed decision.
How to Buy Tax-free Bonds in the Secondary Market
In recent years, issuance of tax-free bonds by PSUs has been limited. If new bonds are issued, you can apply through RBI Retail Direct , authorised banking platforms, and brokerage platforms.
It is easy to buy tax-free bonds through the secondary market via your existing trading/demat account, based on their availability in the secondary market.
- Visit a brokerage website and look up ISIN for the bonds you are interested in
- Check the yield to maturity (YTM), credit ratings, and maturity dates before evaluating bonds
- Consider the bond credit rating and expiry date
- Transactions are generally executed through NSE or BSE-enabled brokerage platforms
Conclusion
If you are exploring fixed-income instruments with tax-exempt interest income, tax-free bonds may be one of the available options. Their AAA credit rating ensures better security and returns that often outperform taxable alternatives with a higher coupon rate on a post-tax basis. You may consider them for long-term portfolio anchoring amid market uncertainties. As new issues are rare, the options may be limited based on the liquidity in the secondary market. You may compare tax-free bonds with other fixed-income instruments such as corporate bonds, G-secs, and FDs based on financial goal, risk tolerance, and investment horizon.
