Tax-Free Bonds
Tax-free bonds are long-tenure debt instruments issued by government-backed public sector entities where the interest income is entirely exempt from income tax under Section 10(15)(iv)(h) of the Income Tax Act, making them particularly attractive for investors in higher tax brackets.
Tax-free bonds occupied a distinctive niche in the Indian fixed-income landscape. Unlike most debt instruments where interest income was added to total income and taxed at the applicable slab rate, interest on tax-free bonds was completely exempt from income tax regardless of the quantum. This made their effective post-tax yield significantly higher than comparable taxable instruments, with the advantage magnifying as the investor's tax bracket increased.
The major issuers of tax-free bonds in India included National Highways Authority of India (NHAI), Indian Railway Finance Corporation (IRFC), Power Finance Corporation (PFC), Rural Electrification Corporation (REC), Housing and Urban Development Corporation (HUDCO), and National Housing Bank (NHB). These issuances were backed by the AAA credit rating of quasi-sovereign entities, giving them near-government-level safety.
The primary issuance window for tax-free bonds was active from approximately 2012 to 2016, after which the government largely discontinued new issuances partly because the subsidy cost to the exchequer was high and other financing channels had developed. However, the bonds issued in that period continued to trade actively in the secondary market on BSE and NSE, with typical face values of Rs 1,000 and retail lots available at reasonable prices.
The effective yield calculation for tax-free bonds required accounting for the tax benefit. A bond with a coupon of 7.5 percent was equivalent, for an investor in the 30 percent tax bracket, to a taxable instrument yielding approximately 10.7 percent (7.5 ÷ 0.70). For a 20 percent bracket investor, the equivalent yield was 9.375 percent. This comparison meant that the bonds became progressively more attractive as one moved up the income tax scale.
Despite their advantages, tax-free bonds had practical limitations. Liquidity in the secondary market was moderate — large institutional lots traded efficiently, but retail investors sometimes faced wide bid-ask spreads. The fixed coupon rates also meant that if prevailing interest rates rose significantly after purchase, the bond's market price would fall, creating mark-to-market losses for those who needed to sell before maturity. Investors who held to maturity avoided this issue but forfeited the flexibility to exit. Most tax-free bonds carried tenures of 10, 15, or 20 years, making them suitable only for investors comfortable with long holding periods.