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Tax-free bonds are only for savvy investors
December, 02nd 2014

With bond yields falling, it could be a good time to invest in some long term debt products like tax-free bonds. As per data from brokerage firm Bonanza Portfolio, Hudco's tax-free bonds, which were issued in May 2012, have given total annualised return of almost 8%. Similarly, Rural Electrification Corporation (REC) and Indian Railway Finance Corporation's (IRFC) tax-free bonds have give an annualised return of 15% and 72%, respectively. Both these were issued in March this year.

Total absolute return from Hudco, REC and IRFC is around 22%, 10.50% and 48.50%, respectively. The coupon or interest income from these bonds is around 8.20% to 8.50%.

ALSO READ: 10-year bond yield falls 5 bps to 8.45%

Hiren Dhakan, associate fund manager, Bonanza Portfolio adds that National Highway Authority of India's (NHAI) bonds are currently trading at Rs 1,124. These were issued in January 25, 2012 and has its next interest payout on October 1, 2015.

“That's a huge premium today considering interest will be paid in October 2015. Despite all the past interest payouts, if the bondholder sells the bond, it would result in an absolute return of 12.4%. The bonds are trading at a premium as yields have fallen, discounting a probable cut in interest rates by the Reserve Bank of India (RBI) in the upcoming monetary policy considering fall in inflation levels,” he explains.

In the last six months, yields on 10-year government security bonds have fallen 58 basis points or 0.58% from 8.645% in May end this year. Yields on these bonds touched a 16-month low of 8.09%.

ALSO READ: New 10-year G-sec yet to become top traded security

Hence, 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 1-2 quarters. Bond prices are inversely proportional to interest rates. Given there is only expectation of a rate cut and no clarity on it, one will need to be sure if they intend to buy and hold these bonds or not.

Vidya Bala, head - research, says, “If an individual investor is looking for capital appreciation then he/she 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. The secondary corporate debt market is not very liquid and trading in bonds are few and far between.

Agrees Dhakan, “Only those investors should buy these bonds who have an investment horizon of more than one year, 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. As per mutual fund rating agency, Value Research, income funds have returned nearly 12% in the last one year and 6.50% in the last six months.

Feroze Azeez, executive director - Investment Products (Private Wealth Management) at Anand Rathi Financial Services has another strategy for slightly savvy investors. “Existing investors of these bonds, trading at yield much below their coupon, have made good capital gains. For instance, a 10-year tax-free bond issued at a coupon of 8.14% in 2013 is currently trading around 7.20%,” he says.

ALSO READ: Long-term tax-free bonds may aid banks' infra push

He further explains by redeeming your investment in tax-free bond 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%), you would make a post-tax, post-expense Internal Rate of Return (IRR) of 8.59% for the next 3 years (higher than 8.14% coupon). Further taking into account the capital gain you make on your original investment, this strategy would generate an IRR of 10% since inception, that is, between 2013 and 2017. The additional earning of 1.85% in the initial four years would mean a compounded additional return of 7.6% for 4 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 next three years to generate a 10% return.

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