Yields on tax-free bonds quite attractive

Last Updated: Wed, Apr 23, 2014 04:12 hrs

Fresh tax-free bond issues are unlikely before October-November. This is why listed bonds are being traded more on the stock exchanges and on the over-the-counter market. According to market operators, such bonds of Rs 200 crore are changing hands daily - and demand is arising across investor categories - by both retail and corporate bodies.

The yields on tax-free bonds are 8-8.75 per cent, making these attractive investment options. For instance, the National Highways Authority of India (NHAI) tax-free bonds (coupon 8.20 per cent; maturity January 2022) with a face value of Rs 1,000 are trading at Rs 1,051, offering a yield to maturity of 8.09 per cent. Though investors will get 8.2 per cent coupon, since one buys these at market prices, higher than the face value, the final yield is a little lower.  

Kartik Jhaveri of Transcend Consulting suggests purchases only in small amounts, Rs 2 to 5 lakh. That's because the secondary market is illiquid for tax-free bonds and buying is not so easy.

However, despite the lack of liquidity, if you look patiently, you will be able to buy a tax-free bond at a good price. Market experts say tax-bond issuances of more than Rs 500 crore are generally more liquid because of a larger retail participation during the time of launch.  

Experts suggest avoiding the series where there is a differential interest for a second buyer. Say a bond buyer gets 8.5 per cent, if he transfers/sells them to another individual. The new buyer will earn only eight per cent. There was no yield difference for issues launched in 2011-12. However, those hitting the market during 2012-13 had the step-down clause, where buyers from the secondary market would get lower coupon rates than the original investors.

Purchasing tax-free bonds in the secondary market makes sense only for those in the 30 per cent tax bracket. Also, they score over fixed deposits. For instance, The State Bank of India's 10-year fixed deposit earns 8.5 per cent. Post-tax returns (to those in the 30 per cent tax bracket) would be 5.87 per cent.

"Even if someone in the highest tax bracket gets 8.5 per cent instead of 8.9 per cent, that is good enough in the present market. At the same time, we do not know if the new government will continue with tax-free bonds. Even if it does, rates in the primary market will be less than in the secondary market," says financial planner Pankaj Mathpal.

Jhaveri points out certain advantages of buying bonds in the secondary market. "While you may not get the same bond yield in a falling interest-rate scenario, you will enjoy capital gains because lower interest rates would lead to higher bond prices." The RBI left key rates unchanged in its policy review this month and is expected to go for a cut only if inflation continues to slide.

However, experts say interest rates aren't likely to fall in a hurry. Though inflation markers are trending lower, interest rates are only likely to come down in the later part of the year or early next year. But if you can hold on for the long term, eight-8.5 percent yield is still very attractive for those who have exhausted other options such as the Public Provident Fund, and even for those who want to build a safer fixed-income portfolio.

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