Tax-free bonds worth Rs 40,000 crore are set to hit the market this financial year, with the government having allowed seven entities to use this route.

Investors are likely to get 7.15-7.25 per cent on 10-year bonds, 7.38-7.43 per cent on 15-year bonds and 7.42-7.47 per cent on 20-year ones. Power Finance Corporation's Rs 300-crore issue, which hit the market last week, offered 7.16 per cent for 10-year, 7.39 per cent for 15-year and 7.45 per cent for 20-year tax-free bonds.

The yields are about 100 basis points (bps) lower than the 8.5-9 per cent offered in 2013-14 but the issues are likely to attract high net worth individuals (HNIs). "There should be a good appetite for these bonds from those in the highest tax bracket, as they have been issued after a gap of more than a year," says Ajay Manglunia, executive vice-president at Edelweiss Financial Services.

Rates are much higher than post-tax yields from bank fixed deposits (FDs). For instance, the effective post-tax yield for a typical bank FD of one to three years, paying 8.25 per cent annually, is 5.8 per cent.

According to a government circular, the ceiling coupon rate for AAA-rated issuers of these bonds would be fixed at 55 bps below the government bond yield for retail investors and 80 bps for other investors. This means if a 15-year government security is quoting at 7.9 per cent, HNIs will get the tax-free bonds at 7.1 per cent and retail investors at 7.35 per cent, resulting in higher capital gains for the latter.

At 7.15-7.47 per cent, the effective pre-tax return for a person in the highest bracket works out to 10.83-11.32 per cent. Retail investors (those investing less than Rs 10 lakh) in the highest tax bracket can get 10.6-11 per cent. "There is no one in the market right now who would pay that kind of a return on AAA-rated paper," says Dwijendra Srivastava, chief investment officer-debt, Sundaram MF.

All tax-free bond issuers are quasi-sovereign entities with an AAA rating, with the exception of Housing and Urban Development Corporation, rated AA+. The bonds will be listed on the exchanges and are expected to be fairly liquid. The coupon or interest is typically paid annually and tax-free. Capital gains on bonds held for less than a year are added to your income, while gains on those held for more than 12 months are taxed at 10 per cent, or 20 per cent with indexation, whichever is lower.

Apart from the coupon rate, investors will benefit from capital gains if interest rates move south during the next few years. Yields on 10-year government bonds have fallen about 90 bps, to 7.84 per cent from 8.73 per cent, in the past year.

"Those in the top tax bracket should look to invest in the longest available tax-free bond," says Srivastava. However, he adds, "Liquidity could be an issue if there is not much demand for the bonds. Also, the bonds carry a duration risk, as it is difficult to predict the interest rate movement over the next 10-20 years."

Investors should also remember that despite the long tenure of these bonds, investors face a reinvestment risk. For, most of these will not be cumulative in nature and so the coupon or interest will have to be reinvested at the rates prevalent at the time of disbursal, say experts.

Competing options

Investors who do not want to park their money for a longer tenure can look at fixed maturity plans (FMP) of mutual funds. According to experts, returns for an FMP of three years or more works out to about 7.5 per cent, assuming six per cent inflation. Gains from three-year FMPs are taxed at 20 per cent with indexation. While FMP returns are slightly higher, tax-free bonds can give better or comparable returns in a softening interest rate environment, say experts.

Those with a longer time horizon can look at preference shares, which can offer yearly post-tax returns of eight to nine per cent. "Dividends are paid out annually but the supply of these shares is fairly limited, and liquidity can be an issue. Tax-free bonds, on the other hand, are much more liquid," says K P Jeewan, head of fixed income, Karvy Stock Broking. The issue size of preference shares is typically Rs 200-500 crore.

Lower tax brackets

For those in the 10 per cent tax bracket, both bank FDs and non-convertible debentures (NCDs) offer a better option, as the post-tax returns are better.

NCDs score over tax-free bonds even for those in the 20 per cent tax bracket, with a post-tax yield of 7.2-8.8 per cent. "Tax-free bonds offer better returns for these investors when compared with FDs and top-rated NCDs. However, returns can be higher for lower-rated NCDs, although these instruments do not fall under the same risk profile," says Manglunia.

NCDs currently offer pre-tax rates of 8.5 per cent for AAA paper, 9-9.5 per cent for AA+ and 10.5-11 per cent for AA- paper, say experts.

Srivastava believes those in the 20 per cent tax bracket can also consider five-year tax-free FDs, which can give annual returns of 8-8.5 per cent, with an effective yield of 10.3-10.96 per cent, as these are compounded quarterly.

Manglunia suggests another strategy. He says those in the 10 and 20 per cent tax bracket can invest in tax-free bonds if they participate for capital gains over the next 12 months, and not for holding till maturity. Heexpects yields to soften by 25-50 bps in the period, which could result in capital gains of four to five per cent.

WILL MONEY MOVE FROM EQUITIES?

The flood of tax-free bond issuance in the second half of the year might prompt savvy investors to move some of their money from short-term income funds and long-duration bond funds. "In a falling interest rate scenario, investors who do not want to stay locked in for three years might consider moving to tax-free bonds," says Ashish Kehair, senior executive vice-president, IDFC, while ruling out any large exodus.

Investors in debt mutual funds have to stay put for three years for their units to be considered long-term. Long-term capital gains are taxed at 20 per cent with indexation. Gains on tax-free bonds held for more than 12 months are taxed at 10 per cent, or 20 per cent with indexation, whichever is lower.

There might be some movement of money from equities, including equity mutual funds, as well. "If the US Fed raises interest rates or if there is no pick-up in corporate earnings, the market may go through a rough phase. If investors sense that there is little or no upside in the foreseeable future, they might shift some money to the tax-free bonds," says Kehair.

However, he clarifies that the movement will not be "caused" by issuance of these bonds but only be a result of any turmoil in the equity market. According to Nilesh Shah, managing director, Kotak MF, investors might move if the returns of equity mutual funds for the past one or two years is less than the coupon offered by tax-free bonds.