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How you can still buy a tax-free bond
May, 19th 2014

The deluge of tax-free bonds offering high interest rates came to an end with the close of the 2014 fiscal. The next round of tax-free bond issues is only expected after the final budget is presented, in 5-6 months.

But you need not wait till then. There are good opportunities available in the secondary market too.

High rates no more
One reason for this is that new issues may not be able to match the high rates offered by tax-free bonds in 2013-14. Tax-free bond rates are linked to 10-year government securities, whose yields were high last year.

Consequently, the market was abuzz with attractive offers, with coupon rates on 10-year bonds ranging from 8.4 per cent to 8.7 per cent.

In 2012-13, similar bonds offered no more than 7 per cent for a similar tenure. If rates start to correct by the end of the coming year, we may not see more high-yield, tax-free bond issues.

The other reason for secondary market action is that, with a decline in rates and the bond prices spike, this also presents an opportunity to pocket capital gains on such bonds.

Basics first
But picking up bonds in the secondary market is quite different from applying for one during the primary issue. Make sure you understand the basics first.

When an issue opens in the primary market, the coupon rate on the bond is clearly stated, which is the annual rate of return. But in the secondary market, the coupon rate does not matter. This is because the bond in the secondary market may trade below or above its issue price. What matters is the yield-to-maturity.

Yield-to-maturity (YTM) is the effective return you earn on a bond through interest and repayments by buying it at its current price. As bond prices fall, yields rise. There is an inverse relationship between the two. YTM is calculated by arriving at the discount rate, which equates the sum of all future cash flows from the bond (interest and principal) to the current price of the bond. This can be done with the help of a financial calculator or excel sheet.

What makes it attractive?
Most of the tax-free bonds that were issued in the latter part of the 2014 fiscal are trading at a premium of about 3-7 per cent to their issue price.

Take, for instance, the tax-free bonds issued by Power Finance Corporation (PFC). These bonds were issued in November 2013 with an 8.43 per cent coupon rate for 10 years at a face value of ?1,000. They are now quoting at ?1,054 on the BSE.

The bond’s YTM works out to 7.7 per cent. Similarly, the NTPC tax-free bonds issued in December 2013 at 8.66 per cent for 10 years are trading at a 5 per cent premium, at ?1,052, with YTM of 7.9 per cent.

So with most bonds trading at a premium, are there are any attractive options?

How they compare
Some tax-free bonds in the market offer YTM of 8.1-8.3 per cent, which is still attractive, since interest earned annually is not taxed, unlike other fixed-income products.

Most banks offer around 9 per cent interest on deposits with a tenure over five years. But after tax, the rate drops to 8.1 per cent, 7.2 per cent, and 6.1 per cent in the 10, 20 and 30-per cent tax brackets, respectively. Those in a higher tax bracket will gain the most investing in such bonds.

Considering the yield and price, here are a few tax-free bond options in the secondary market that still look attractive.

The NHPC tax-free bond that was issued in November 2013 at 8.43 per cent for 10 years is trading close to its issue price, at ?1,002. Thus, the YTM works out to an attractive 8.4 per cent.

Similarly, the IIFCL bond issued in January this year at 8.66 per cent is now trading at ?1,050, translating into a YTM of 8.1 per cent. Be aware there might be huge volatility in prices and volumes on a daily basis. You can use an online YTM calculator before deciding to buy.

Other deciding factors
After identifying bonds with attractive yields, compare ratings. While most tax-free bond issuers are rated AAA, there are bonds that carry a lower rating too. While they may offer better yields, it is better to stick with higher-rated bonds.

All bond options discussed above are AAA-rated.

Next, while it is advisable to hold the bonds till maturity, circumstances may warrant an earlier sale. In such a scenario, liquidity will be important. In most cases, the daily traded quantity is low and ranges from 50 to 300. So it is important to keep a close watch on volumes.

Finally, there has been a change in the rules regarding coupon rates for retail investors. The bonds launched in 2011-12 did not offer different rates for retail and non-retail investors.

In 2012-13, retail investors were offered higher rates, but buyers of bonds in the secondary market were not entitled to these higher rates. The rule was changed again in 2013-14, where retail buyers in the secondary market (up to ?10 lakh) are entitled to the higher (25 basis points) coupon rates available at the time of the primary issue. So if you are looking at some of the earlier options, do take into account these changes in rules.

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