Tax-free bonds score in secondary market

As interest rates are expected to move south, many savvy investors are buying tax-free bonds in the secondary market. Some of these an effective yield of over seven per cent or 10 per cent return before tax — an attractive rate for those in the highest income tax bracket.

"We are advising the clients who are looking to make fresh investments in debt to add tax-free bonds in their portfolio. It's a good time to get into these bonds. With pre-tax returns of around 10 per cent, they are attractive compared to other instruments," says Sriram Iyer, chief executive officer of Religare Wealth Management. These bonds are liquid and are issued by companies that are not only backed by the government but also have high credit ratings. "The interest rate risk at present is also low as rates are expected to go down further. These factors make them extremely safe to invest," Iyer says.

​State Bank of India's 10-year fixed deposit offers seven per cent interest. For those in 30 per cent tax bracket, the effective rate goes down to around five per cent. For a similar tenure, in the past, debt funds have returns between 7.14 per cent and 8.54 per cent before tax. Many of tax-free bonds, including recent issues of National Highways Authority of India (NHAI), have yields at around seven per cent and offer stable returns for a long tenure.

An investor, however, needs to keep in mind that buying bonds from secondary market carries interest rate, credit and market risks. The secondary market for bonds in India is also not well developed. "It's only recently, after tax-free bond issues, that there's a rise in interest from individual investors," says Vikram Dalal, managing director of Synergee Capital Services. Experts say that it's possible in future, when interest rates start rising, these securities might not remain as liquid. Investors may then need to offload the bonds at a loss. Buyers, therefore, need to be prepared to hold them until maturity. They also need to select the issuer carefully as downgrading the credit profile of the company can affect bond prices.

"These bonds make sense at present if they offer yields at around seven per cent. If their effective yields are below 6.7-6.8 per cent, then investors can look at other options," says Malhar Majumder. He says that debt mutual funds that invest in short-term papers can give similar post-tax returns if an investor holds them for three years or more.

An individual needs to check and compare the pre-tax as well as post-tax yields from these bonds with other available options. When bond investors mention yield, they usually refer to yield-to-maturity (YTM). YTM shows the total return a person will receive if he holds the bond to maturity, which includes interest payment plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).

If you don't want to do it yourself, you can also approach intermediaries or brokers that help investors buy and sell bonds. For a 15-year bond, the charge can be as low as 0.1 per cent or 10 basis points (bps) as commission and for 10-year bond the brokerage is 15 bps.

The minimum investment that brokers would look at is Rs 1 lakh to Rs 2 lakh for each transaction. Before investing, also look at the issue size as it may impact liquidity. NHAI's Rs 10,000-crore bond issue, for example, has the highest traded volume on stock exchanges. Look at the credit rating of the issuer and finally the tenure of the bond. In recent tax-free bond issues, the retail investment limit was up to Rs 10 lakh, which fetched higher interest rates.

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Rajesh Kathpalia | Area Manager
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