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Secondary market can offer good deals on tax-free bonds
April, 11th 2014

If you are waiting for the next tax-free bond issue to invest, be prepared to wait till September. According to distributors, tax-free bond issues are unlikely until the next budget, followed by a Central Board for Direct Taxes (CBDT) notification on the future issuance of tax-free bonds. However, many financial advisors say investors need not wait for new issues and they will get better bargains in the secondary market.

"Tax-free bonds from previous issuances are available in the secondary market. These bonds can fetch you a return of 8.15-8.80 per cent," says Vikram Dalal, MD, Synergee Capital. For example, NHB bonds (coupon 8.51 per cent and maturing in January 2024) with a face value of Rs 5,000 is currently traded at Rs 5,080, offering a yield of 8.56 per cent.

Apart from the higher yield, investors can also expect a capital appreciation in these bonds when interest rates start falling. "Tax-free bonds work better than bank fixed deposits for those in the higher tax bracket, because of higher yields and the opportunity of capital appreciation," says Deepak Panjwani, head (debt markets), GEPL Capital.

Spotting Right Bets Buying a new issue of bonds from the primary market is entirely different from purchasing bonds from the secondary market. All you have to do to subscribe to a new issue in the primary market is just take a look at the tenure and the rates offered and fill up the form and submit it. However, you need a demat account and a stock-trading account with a broker if you want to pick up bonds from the secondary market.

The next step is to identify bonds, compare tenure and yields, liquidity and their ratings. This won't be an easy task for regular individuals. And the constant change in government rules make the task even more cumbersome.

For example, the first series of tax-free bonds launched in 2011-12 had same rates for both retail and institutional investors.

However, in 2012-13, there was a step-down clause, which meant that buyers of these bonds in the secondary market would get a lower interest rate compared to the original investor who invested in the public offer.

The rules were again changed for 2013-14. This time you will be treated as a retail investors if the value of your holding in these instruments is Rs 10 lakh or less when the interest has been declared. Liquidity of bonds is another important factor retail investors need to keep in mind.
"Choose bonds with a bigger issue size as it increases the chances of them getting traded more in the secondary market," says Jyotheesh Kumar, senior vice-president, HDFC Securities.

Play for capital appreciation

Tax-free bonds score over fixed deposits, especially for those in the higher tax bracket. SBI, for example, pays 8.5 per cent for a 10-year fixed deposit. After paying a 30.9 per cent tax on this, your post-tax returns work out to be 5.87 per cent.

Tax-free bonds with a tenure of 10-years can give you a return of 8.2 to 8.5 per cent. Also, you have an opportunity to pocket capital appreciation when interest rates start moving down.

"We expect interest rates to move down by 50-75 basis points over the next one year. Broadly, a reduction in interest rates by 1 bps could give you a capital gain of 7-12 paisa, depending on the tenure of the bond you hold," says Punjwani.

For example, suppose you buy an NHB tax-free bond at Rs 5,080 and its price moves up to Rs 5,330 after a year, giving you a capital appreciation of approximately 5 per cent.

Add your yield of 8.56 per cent to this and your total returns zooms to 13.56 per cent. However, investors should remember that that long-term capital gains from bonds are taxed at 10 per cent.

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