Tax-free bonds are the latest fad in the money markets, especially after the government did away with fresh issues in the current financial year that started on April 1, limiting supplies of such securities. Demand for these bonds is so high that even on a day when yields in government securities markets rose, yields on tax-free bonds fell. Bond yields and prices move in opposite direction. "Yields on tax-free bonds in the secondary market have already fallen by 10 to 15 basis points post-Budget," said Joydeep Sen, senior vice-president - advisory (fixed income) at BNP Paribas Wealth Management.

"It makes sense to buy from the secondary market even at current levels as the credit quality is of the highest grade and coupon receipts are tax-free." Investors are now going to the secondary market to buy those bonds offering lucrative rates over the long-term. Yields on triple-A rated papers such as National Highways Authority of India, REC, India Infrastructure Finance Corporation, PFC, NTPC, National Housing Bank and Indian Railway Finance Corporation fell by up to 15 basis points across maturities ranging from seven to 15 years on the day after the Union Budget.

On the same day, the benchmark 10-year government bond yield shot up to 8.84 per cent — its highest level since the Modi government took charge. "In 2014-15, there would be no fresh issuance and this will limit the supply side," said Deepak Panjwani, head - debt markets at GEPL Capital. "Due to this reason, yields are falling sharply as investors rush to buy tax-free bonds."

In 2013-14, the government allowed 13 public sector institutions to raise Rs 48,000 crore through tax-free bonds to meet their investment needs. In the Union Budget 2014-15, there was no announcement on new issuances of tax-free bonds. However, the absence of such an announcement is seen as a positive for existing bonds. With the possibility of a future rate cut, these bonds stand to offer higher rates. For example, 8.75 per cent coupon NHAI bonds maturing in 2029 quoted an annualised yield of 8.07 per cent on Friday while 8.10 per cent IRFC notes maturing in 2027 were at 7.94 per cent, according to GEPL Capital which sourced data from NSE and BSE.

There is potential for capital gains over the holding period in these bonds as and when interest rates come down further. Existing bond-holders, who are now expected to bargain hard to get a better deal, too, will gain from secondary market sales, dealers said. Markets mostly expect RBI to cut rates by December as inflation eases. "For an investor who may have lakhs of surplus money, it makes sense to invest in those tax-free bonds even in the secondary market," said Suresh Sadagopan, principal planner at Ladder 7 Financial, an advisory firm. "In comparison to bank fixed deposits post-tax, they offer much better rates."

The only option to obtain higher rates than tax-free bonds is the public provident fund, which currently offers 8.70 per cent. However, the investment limit is Rs 1,50,000 a year, a ceiling that was raised in the Budget by Rs 50,000.