When it comes to tax-saving investments, both Equity Linked Savings Schemes (ELSS) and Tax-Free Bonds are popular choices among Indian investors. However, they are very different in terms of risk, returns, liquidity, and lock-in period. Understanding their features can help you make an informed investment decision that aligns with your financial goals and risk appetite.
In this detailed guide, we will compare ELSS vs. Tax-Free Bonds across various parameters, including returns, taxation, risk, and more.
What is ELSS?
ELSS (Equity Linked Savings Scheme) is a type of mutual fund that primarily invests in equity markets. It is eligible for tax deduction under Section 80C of the Income Tax Act, 1961. ELSS funds come with a 3-year lock-in period, the shortest among all tax-saving instruments under 80C.
Key Features of ELSS:
- Invests in equities and equity-related instruments
- Eligible for tax deduction up to ₹1.5 lakh under Section 80C
- Shortest lock-in period of 3 years
- Returns are market-linked
- Can be invested through SIPs or lump sum
What are Tax-Free Bonds?
Tax-Free Bonds are long-term debt instruments issued by government-backed entities like NHAI, PFC, IRFC, and REC. These bonds offer fixed interest income, and the interest earned is completely tax-exempt under Section 10(15) of the Income Tax Act.
Key Features of Tax-Free Bonds:
- Issued by government institutions
- Interest is tax-free
- Long tenure of 10-20 years
- Very low risk
- Fixed interest income (usually 5.5% to 6.5%)
ELSS vs. Tax-Free Bonds: A Detailed Comparison Table
| Feature | ELSS | Tax-Free Bonds |
|---|---|---|
| Investment Type | Equity Mutual Fund | Government-backed Debt Instrument |
| Risk Level | High | Very Low |
| Returns | 10%–15% (Market-Linked) | 5.5%–6.5% (Fixed) |
| Lock-in Period | 3 Years | 10–20 Years |
| Tax Deduction (Sec 80C) | Up to ₹1.5 lakh | No Deduction Under Sec 80C |
| Tax on Returns | LTCG @10% (above ₹1 lakh) | Interest is fully tax-free |
| Liquidity | Moderate (after 3 years) | Low (long-term, limited trading) |
| Suitable For | Growth-oriented investors | Conservative, income-seeking investors |
| Investment Mode | SIP or Lump Sum | Lump Sum (during bond issuance) |
1. Returns: ELSS Offers Growth, Bonds Offer Stability
ELSS:
ELSS funds invest in equity markets, which means the returns are market-linked and not guaranteed. Historically, ELSS funds have delivered average returns between 10% to 15%, depending on market performance.
Tax-Free Bonds:
On the other hand, tax-free bonds offer fixed interest rates (usually 5.5% to 6.5%). The interest is paid annually and is not subject to income tax, making them suitable for investors looking for predictable income with tax benefits.
2. Risk Profile: High vs. Low
ELSS:
Being equity-based, ELSS carries market risk. It can experience short-term volatility, but over the long term, equities have historically outperformed other asset classes.
Tax-Free Bonds:
These are low-risk instruments since they are issued by government-backed entities. There is virtually no default risk, making them ideal for risk-averse investors.
3. Tax Benefits: Section 80C vs. Tax-Free Interest
| Tax Benefit | ELSS | Tax-Free Bonds |
|---|---|---|
| Section 80C Deduction | Yes, up to ₹1.5 lakh | No (doesn’t qualify under 80C) |
| Tax on Returns | LTCG @10% (after ₹1 lakh gain) | No tax on interest |
| TDS Applicable? | No | No |
- ELSS offers upfront tax deduction under Section 80C.
- Tax-free bonds don’t offer 80C benefits, but the interest earned is completely exempt from tax.
4. Lock-in Period and Liquidity
ELSS:
ELSS has a mandatory lock-in of 3 years, after which investors can redeem their units. This is the shortest lock-in among all 80C options.
Tax-Free Bonds:
These bonds have a long maturity period of 10 to 20 years. Though they can be traded in the secondary market (on stock exchanges), liquidity is low, and the market price can vary based on interest rate movements.
5. Who Should Invest in ELSS?
ELSS is best suited for:
- Young and middle-aged professionals
- Investors with a long-term horizon
- Those comfortable with market volatility
- People seeking wealth creation and tax-saving
By starting a Systematic Investment Plan (SIP) in ELSS, investors can benefit from rupee-cost averaging and power of compounding.
6. Who Should Invest in Tax-Free Bonds?
Tax-free bonds are ideal for:
- Retired individuals or senior citizens
- Risk-averse investors
- Investors looking for fixed annual tax-free income
- High-income individuals in the 30% tax bracket
These bonds can help maintain capital safety while generating steady, tax-free income over the long term.
7. Impact of Inflation on Returns
| Instrument | Nominal Return | Inflation-Adjusted Return |
|---|---|---|
| ELSS | 10%–15% | 6%–10% |
| Tax-Free Bonds | 5.5%–6.5% | 1%–3% |
While tax-free bonds offer guaranteed income, inflation erodes purchasing power over time. ELSS, with its equity exposure, has the potential to beat inflation, making it a better choice for long-term wealth creation.
8. Investment Horizon: Short, Medium or Long Term?
- ELSS: Suitable for medium to long-term goals (3–10 years)
- Tax-Free Bonds: Ideal for long-term passive income (10–20 years)
9. Performance Comparison – Sample Case Study
Let’s assume you invest ₹1,50,000 in each option for comparison.
| Particulars | ELSS Investment (10% CAGR) | Tax-Free Bonds (6%) |
|---|---|---|
| Duration | 10 Years | 10 Years |
| Maturity Amount | ₹3,89,000+ | ₹2,50,000 |
| Tax on Returns | LTCG on ₹2,39,000 = ₹13,900 | Zero |
| Net Gain After Tax | ₹3,75,100 | ₹2,50,000 |
Conclusion: ELSS outperforms tax-free bonds by a wide margin over a 10-year period, even after considering LTCG tax.
10. ELSS vs. Tax-Free Bonds: Summary of Pros and Cons
| Aspect | ELSS – Pros | ELSS – Cons | Tax-Free Bonds – Pros | Tax-Free Bonds – Cons |
|---|---|---|---|---|
| Returns | High, market-linked | Volatile, no guarantee | Fixed, tax-free | Lower returns |
| Tax Benefits | 80C + LTCG | LTCG beyond ₹1 lakh taxed | Interest is fully exempt | No 80C deduction |
| Liquidity | 3-year lock-in | Lock-in unavoidable | Tradable, but illiquid market | Locked-in till maturity |
| Risk | High, equity exposure | Market dependent | Very low, government-backed | Interest rate risk in secondary |
| Ideal For | Growth-oriented investors | Not for conservative | Retirees, conservative savers | Not for short-term needs |
Final Thoughts: ELSS or Tax-Free Bonds – What Should You Choose?
- Choose ELSS if you are looking for high returns, can tolerate market risk, and have a long-term investment horizon.
- Opt for Tax-Free Bonds if you seek steady income, prefer capital preservation, and fall in a higher tax bracket.
In some cases, having both in your portfolio can offer the right mix of growth and safety, depending on your age, income, and financial goals.