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Tax-free bonds may be your best bet to gain from softer interest rates
June, 13th 2013

Tax-free bonds have always been a favourite with investors. Now, there is an even bigger reason for investors to lap them up. The bonds of PFC, REC, Hudco and NHAI, all issued in the first quarter of 2012, have increased in value by 5-15 per cent as rate cut hopes drive up prices. The 15-year 8.3 per cent NHAI - N2 bond (face value of Rs 1,000 and interest paid annually), issued in January 2012, is quoting at Rs 1,170, a gain of 10.8 per cent in one year, while the 15-year 8.12 per cent REC bond has moved up from Rs 1,010 to Rs 1,175 in the same period. Though yields have fallen by 100-110 basis points (prices and yields move in opposite directions), experts are advising investors to stay invested and even buy some more as inflation slows and the interest rate environment becomes more benign.

The calculation works this way. If inflation moves down and interest rates also move downward by another 50 basis points, the 10-year bond could see a capital appreciation of 2.5-3.0 per cent, while a 15-year bond could appreciate by another 4-5 per cent. "Investors should hold on to them," says Deepak Punjwani, head (debt markets), GEPL Capital. Investors with an appetite for tax-free bonds could even look to buy these from the secondary markets, he adds.

The equity market's rough patch means that companies can raise money through tax-free bonds for long-term infrastructure projects at competitive rates. In the last two years alone, companies have raised Rs 55,000 crore through tax-free bonds. More such issues are expected this year as well but the advantage for investors in existing bonds is that the new issues will be priced at 100 basis points lower than the existing 10-year G-sec yields.

Existing tax-free bonds are giving a yield of 6.9-7.19 per cent. Given the soft interest rate environment, new issuances could be at lower yields. "Investors with an appetite for tax-free bonds can consider buying these from the secondary markets," says Ajay
Manglunia, SVP (fixed income), Edelweiss Capital.

Financial experts are betting that lower inflation will push up bond prices. The declining price of food items, including fruits and vegetables, pulled down inflation to a three-and-ahalf year low of 4.89 per cent in April compared with 5.96 per cent in March 7.50 per cent in April 2012. "The central bank may cut rates by another 25 basis points by August or September," says Mahendra Kumar Jajoo, executive director and chief investment officer, Pramerica Mutual Fund.

An interest rate cut could see bond prices move up. Take the case of 8.2 per cent Hudco - N2 option with a tenure of 15 years. The bond trades at Rs 1,110, giving a yield of 7.16 per cent. "For every dip in interest rates by 100 basis points, an investor could get a capital appreciation of 75-100 paise," says Deepak Punjwani.

Now if interest rates were to drop by 50 basis points within the next one year, this bond could give you a capital appreciation of Rs 25-30, which translates to 2.5 per cent. That means after adding the coupon rate of 8.2 per cent plus the capital appreciation 2.5 per cent, you could get a return of 10.7 per cent. Similarly, AAA-rated, 8.3 per cent NHAI bond maturing in 2027, which trades at Rs 1,165 and offers a yield of 6.97 per cent per annum, could appreciate by Rs 25 if interest rates were to drop by 50 basis points. That means your total returns could go up to 10.8 per cent (adding the coupon rate of 8.3 per cent plus capital appreciation of 2.5 per cent).

Those with an appetite for tax-free bonds could look at buying these from the secondary market as these are liquid and easily available. Tax-free bonds of NHAI, PFC, REC, IRFC and Hudco trade in the secondary market with a yield of 6.90 and 7.19 per cent. For example, the 8.02 per cent PFC bond maturing in 2022, trades at Rs 1,124, giving a yield of 7.03 per cent. So, while a 10-year bank fixed deposit from the State Bank of India gives 8.75 per cent, the effective after tax return for an investor in the high tax bracket would be 6.05 per cent.

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