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Get ready for tax-free bonds
September, 02nd 2013

The market will soon be flooded with taxfree bonds. Even as the government has allowed several PSUs to raise up to 48,000 crore during 2013-14 (see table), the Rural Electrification Corporation (REC) is the first one to hit the market.

The tax-free bond issues that had come out earlier this year in February and March had failed miserably, with most companies failing to raise the mandated amounts. At that time, bond yields were quite low, with the 10-year yield quoting below 8%, so the investors didn't bite the bait.

Things are different this time round. The benchmark 10-year yield crossed 9% recently, but closed lower. The companies with a AAA rating are allowed to offer 55 basis points less than the reference government bond rates to retail investors . Retail investors are defined as resident individuals , HUFs or NRIs, who invest up to 10 lakh across all series of bonds in each tranche. This means that an individual can invest in the next tranche or in an issue by another company and still be in the retail category. If the benchmark rate is 9%, the maximum yield offered will be 8.45% for retail investors and 8.2% for others. However , these are maximum rates and issuers can offer a lower interest if they wish.

Tax advantage

The biggest draw for the investor is that the interest earned from these bonds is tax free. Assuming a tax-free coupon yield of 8.2%, the implied pre-tax rate will be to the tune of 11.79% for investors in the 30% tax bracket. Since the recent spike in the bond yield was largely due to the RBI's short-term efforts to prop up the rupee, the yield is likely to fall once the currency stabilises. If the yield falls, the value of these bonds will shoot up in the secondary market. The investors will have the opportunity to book profits by selling these bonds. While short-term capital gains from such a sale will be taxed as normal income, long-term capital gains will be taxed at 10%. The bonds must be held for at least 12 months for the profits to be treated as long-term gains.

What to look for

The most important factor is the rating. The REC has been assigned a AAA rating by agencies. While it is better to go with the AAA-rated companies, experts are advising investors not to follow this rule mechanically. Even AA+ companies, such as Hudco, can be a good investment. "Since all of them are government enterprises, there is no default risk. So investors can take advantage of the yield difference by putting money in AA+ companies ," says Gajendra Kothari, managing director and CEO, Etica Wealth Management.
Liquidity is the next important thing. Liquidity is critical even for the long-term investors who plan to hold these bonds till maturity. What if they have to liquidate these instruments due to unforeseen circumstances? These are all primary issues and, therefore, it is impossible to predict the exact liquidity after they list. However, you should give preference to companies that are planning to list on both the BSE and the NSE. The size of the issue is another indicator. The larger the amount, the higher the probability of good volume after listing.

Choose the right tenure

Unlike the previous issues, the latest offerings will have the option of a 20-year term. There are no put or call options for these bonds, so you must decide the time period for which you want to remain invested. Experts are advising investors to go for long duration bonds as they offer higher coupon rates compared to the 10-year bonds. Long duration bonds also reduce the reinvestment risk. "Since the interest rates are expected to come down in the long term, you may not get the high interest rates after 10 years," says Kothari. The price volatility will also be higher for long duration bonds and, therefore, the potential to earn capital gains will also be higher.
One also needs to consider the gap between the rates offered to retail and other investors. The former will get the higher yield only till they hold these bonds in their own name. In other words, secondary market purchasers are not treated as retail investors and, therefore, they will get only the lower coupon rate. Due to this, the market price will be based on these stepped down coupon rates. So go with the issues with the lowest gap.

Secondary market route

With prospects of new issues hitting the market with higher coupon rates, existing tax-free bonds have started correcting. Market forces will not allow a difference in yields of the existing and new bonds. This means investors can get good deals in the secondary market, but their tenures will not be as long as those for the new issues.

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