Tax-free bonds on Zerodha
Tax-free bonds are a category of bonds whose interest income is exempt from income tax under Section 10(15)(iv)(h) of the Income Tax Act, 1961. They are issued by government-backed entities (primarily Public Sector Undertakings) as notified by the Ministry of Finance under specific budget allocations. Zerodha does not facilitate primary issuance of tax-free bonds, but investors can buy and sell previously issued tax-free bonds in the secondary market through Kite on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
What qualifies as a tax-free bond
The interest income exemption under Section 10(15)(iv)(h) applies only to bonds issued by specific entities notified by the Central Government in the Official Gazette under the authority of the Finance Act of the relevant year. The exempt entities have historically included:
- National Highways Authority of India (NHAI)
- Rural Electrification Corporation (REC)
- Power Finance Corporation (PFC)
- Housing and Urban Development Corporation (HUDCO)
- Indian Railway Finance Corporation (IRFC)
- National Housing Bank (NHB)
- NTPC Limited
- Indian Renewable Energy Development Agency (IREDA)
The last significant primary issuance of tax-free bonds in India was in the financial years 2013-14 and 2014-15. No new tax-free bond tranches have been notified since the Budget 2016-17, meaning investors can only access existing tax-free bonds in the secondary market.
Secondary market access on Zerodha
All previously issued tax-free bonds that are listed on NSE or BSE can be bought and sold through Kite. To find tax-free bonds on Kite:
- Search for the issuer name in the bond search (e.g., “NHAI,” “IRFC,” “REC”).
- Identify the specific ISIN (each bond series has a unique ISIN reflecting its coupon rate and maturity date).
- Place a limit order in the debt segment.
Tax-free bonds trade with low frequency in the secondary market. Average daily volumes can be small, and bid-ask spreads of 0.5% to 2% are common. Investors must use limit orders and may wait hours or days for a match at the desired price.
Coupon rates and maturities
Tax-free bonds issued in 2013-15 carry coupon rates ranging from approximately 7.0% to 8.5% per annum depending on the issuer, tenure (10, 15, or 20 years), and the prevailing interest rate environment at issuance. Common maturities outstanding as of 2026 include bonds maturing in 2024-25, 2028-30, and 2033-35.
Given that benchmark G-Sec yields have moved since issuance, the secondary market yields of tax-free bonds are typically lower than comparable corporate bond yields, reflecting the tax exemption premium. For investors in the 30% tax bracket, a 5.5% tax-free yield is equivalent to a taxable yield of approximately 7.9% (pre-tax equivalent yield = tax-free yield / (1 - marginal tax rate)).
Pre-tax equivalent yield calculation
The value of the tax exemption depends on the investor’s marginal tax rate:
| Tax bracket | Tax-free bond yield | Pre-tax equivalent yield |
|---|---|---|
| 30% (plus surcharge) | 5.5% | ~8.0%+ |
| 20% | 5.5% | ~6.9% |
| 10% (new regime) | 5.5% | ~6.1% |
| Zero tax | 5.5% | 5.5% |
Tax-free bonds are most beneficial for investors in the 30% tax bracket or above (including those with surcharge on high incomes). Investors in lower tax brackets may find equivalent yields in corporate bonds or regular debt funds without the liquidity constraints of tax-free bond secondary markets.
Brokerage and charges
| Charge | Amount |
|---|---|
| Brokerage | Rs 20 or 0.03% per executed order |
| Exchange transaction charge | BSE/NSE: nominal |
| STT | Not applicable |
| GST | 18% on brokerage |
| Stamp duty | Applicable |
| TDS on interest | Not applicable (interest is exempt from income tax; no TDS) |
Tax-free bond interest is exempt from TDS. Issuers do not deduct tax at source on coupon payments for resident investors.
Tax treatment
Interest income
Tax-free bond interest is exempt from income tax under Section 10(15)(iv)(h) for all resident investors regardless of tax bracket. No disclosure of this income as taxable income is required; however, Schedule EI (Exempt Income) of the ITR form requires the interest amount to be disclosed as exempt income.
Capital gains on secondary market sale
If tax-free bonds are sold in the secondary market before maturity, the gain or loss is subject to capital gains tax:
- Short-term (held less than 12 months from purchase date): Taxed at slab rate. Note: For listed bonds, the holding period for LTCG was revised. Earlier it was 12 months; it may now be 24 months or 36 months depending on current law. Investors should verify the applicable holding period under the most recent Finance Act amendment.
- Long-term: 10% without indexation or 20% with indexation under Section 112, depending on which is more beneficial.
Maturity proceeds
At maturity, the issuer redeems the bond at face value. No capital gains tax arises if purchased at face value. If purchased at a premium (above face value in the secondary market), the loss on redemption at face value may be claimed as a capital loss.
Key risks
- Interest rate risk: Tax-free bond prices decline when market interest rates rise (inverse relationship). Long-tenor bonds (20 years) have high modified duration and price sensitivity.
- Liquidity risk: Secondary market volumes are thin. Selling a large holding quickly may require accepting a significantly lower price.
- Reinvestment risk: At maturity, investors may not find comparable tax-free yields in new instruments.
- No new issuance risk: The government has not issued new tax-free bond notifications since 2016-17. The existing pool is finite and shrinking as bonds mature.
References
- Income Tax Act, 1961, Section 10(15)(iv)(h), Tax exemption for notified bond interest.
- Ministry of Finance Notification, Tax-free bond authorisation (various years: 2013-14, 2014-15).
- SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.
- NSE/BSE, Listed tax-free bonds ISIN directory.
- Income Tax Act, 1961, Section 112, Capital gains on debt instruments.