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Tax-free the new mantra as bond yields fall
December, 03rd 2014

With bond yields falling, it could be a good time to invest in some long-term debt products like tax-free bonds.

According to brokerage firm Bonanza Portfolio data, Hudco’s tax-free bonds, which were issued in May 2012, have given total annualised return of almost 8.27 per cent (as on December 2). Similarly, Rural Electrification Corporation (REC) tax-free bonds have given an annualised return of 15. REC bonds were issued in March this year.

Total absolute returns from Hudco and REC stand at around 23 and 10.5 per cent, respectively. The coupon or interest incomes from these bonds stand at 8.2-8.4 per cent.

Hiren Dhakan, associate fund manager, Bonanza Portfolio, adds National Highway Authority of India (NHAI)’s bond is currently trading at Rs 1,124. These were issued on January 25, 2012, and will have its next interest payout on October 1, 2015.

“That’s a huge premium today considering interest will be paid in October next year. Despite all the past interest payouts, if the bondholder sells the bond, it would result in an absolute return of 12.4 per cent. The bonds are trading at a premium as yields have fallen, discounting for a probable cut in interest rates,” he explains.

Yields on 10-year government security bonds have fallen 58 basis points or 0.58 per cent from 8.645 per cent by May-end this year. Yields on these bonds touched a 16-month low of 8.09 per cent.

Dhakan believes individual investors who missed the bus could park some funds in these bonds. Additionally, prices of these bonds would run up once RBI cuts interest rates in the next one or two quarters. Bond prices are inversely proportional to interest rates. Given there is only expectation of a rate cut and no clarity on it on the exact timeline, one will need to be sure if they intend to buy and hold these bonds or not.

Experts, however, are also advising caution for novice investors. Vidya Bala, head, research,, says, “If an individual investor is looking for capital appreciation then he should be a savvy investor who knows when to exit, as it would mean taking a call on interest rates.” Otherwise, she feels, tax-free bonds are not suitable enough for retail investors, as now these will need to be bought in the secondary market. Also, the secondary corporate debt market is not very liquid and trading in bonds is few and far between.

Dhakan says, “Only those investors with an investment horizon of more than one year should buy these bonds, in case RBI delays rate cuts.”

A simpler solution for individuals would be to take exposure in debt mutual funds — income funds. Many of these have taken position in the long-term government securities, says Bala. This would also diversify your debt portfolio into various bonds across maturities. According to mutual fund rating agency Value Research, income funds have returned nearly 12 per cent in the last one year and 6.5 per cent in the last six months.

Feroze Azeez, executive director, investment products (private wealth management), Anand Rathi Financial Services, has another strategy for slightly savvy investors. “Existing tax-free bonds are trading at yields much below their coupon, and have delivered good capital gains. For instance, a 10-year tax-free bond issued at a coupon of 8.14 per cent in 2013 is currently trading around 7.20 per cent,” he says.

He further explains by redeeming your investment in tax-free bonds invested in 2013 or earlier and investing the proceeds in a high quality portfolio of mainly AAA rated papers (currently offering a yield of 8.6 per cent), you would make a post-tax, post-expense Internal Rate of Return (IRR) of 8.59 per cent for the next three years (higher than 8.14 per cent coupon).

Further, taking into account the capital gain you make on your original investment, this strategy would generate an IRR of 10 per cent since inception, that is, between 2013 and 2017. The additional earning of 1.85 per cent in the initial four years would mean a compounded additional return of 7.6 per cent for four years. If you stay invested in the tax-free bond, the bond would have to fall by around 90 basis points from current levels in the next three years to generate 10 per cent

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