Investments in tax-free bonds in the past year would have fetched you as much returns as mid and small-cap equity schemes -the best performing mutual fund category. The bonds have returned 25-27% on an annualised basis led by a sharp rally in the bond market of late. Between January and March, Nabard, Hudco and IRFC, among others, had come out with tax-free bonds. These firms raised money at rates between 7.6% and 7.7%.
“The returns comprise two components interest income on the bonds and capital appreciation,“ says Vikram Dalal, managing director, Synergee Capital. Bond prices appreciated as interest rates cooled off and liquidity improved.
The benchmark 10-year fell from 7.5% in March and currently trades at 6.73%, leading to a sharp appreciation in the prices of these bonds.
Even after this sharp appreciation, wealth managers advise investors to hold on to the bonds or even add more. Firstly , there will be no fresh issue in this financial year in the primary markets. Secondly , these bonds at the current market prices give investors a yield between 6.4-6.45% per annum. As inflation cools off and remains low, interest rates are further expected to cool down, which could lead to a even more capital appreciation from these bonds.
“The 10-year benchmark will come down to levels of 6% over the next 12 18 months. This could result in investors getting a return of 14-15% if they buy tax-free bonds at these levels,“ says Dalal. He expects the yields on these bonds to move down to touch 5.50-5.75% in a year's time. Dalal says he is reminded of the years 2004-05 and 2005-06 when 6.75% UTI US 64 bonds and 6.60% UTI ARS bonds were trading at a yield of 5.00 5.25%.
These bonds score over traditional instruments such as fixed deposits, especially for those in the higher tax bracket, even if one does not consider capital gains. A 10-year fixed deposit from SBI , for instance, fetches 7.25% annualised returns. After paying a 30.9% tax, your post-tax returns work out to 5.01%.
Tax-free bonds with a tenure of 15 years can give you a return of 6.4% to 6.5%. In addition, you have an opportunity to pocket capital appreciation when interest rates start moving down. These bonds carry negligible risk as they are AAA rated and issued by government-owned companies. These bonds have tenure of 15 years and have no put or call options.