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A second chance to bond, tax-free
September, 21st 2015

After the Budget allowed seven public sector firms to raise ?40,000 crore via tax-free bonds this fiscal, a series of such bonds were expected to hit the markets. But after Power Finance Corporation, the first issuer this year, others chose to skip the public issue route. Instead, they raised money through the private placement route, which is open to only institutions and high net worth individuals.

But even as plenty of action is expected in the primary market for bonds, market participants suggest that there are good opportunities in the secondary market too. So how can you cherry-pick these bonds in the secondary market?

Attractive yields
Tax-free bonds offer far better returns when compared to fixed deposits, particularly for investors in the highest tax bracket. Since interest from fixed deposits is taxable, a 7.16 per cent for 10 years like the one offered by PFC, is equivalent to 10.4 per cent interest in fixed deposits (highest tax bracket).

This fiscal, the yields on these bonds are far lower than the 8.4-8.5 per cent offered in 2013-14.

Tax-free bonds that are AAA rated can offer up to 55 basis points lower to the G-Sec yield to retail investors and 80 basis points lower for other investors.

With the G-Sec yield hovering around 7.7 per cent, these bonds can offer rates close to 7.1 per cent for a 10-year period.

With tax-free bonds clearly trumping the humble fixed deposits on interest rates, are HNIs waiting to cash in on these bonds when they hit the market?

Not quite so, according to Ashish Shanker, Head - Investment Advisory, Motilal Oswal Private Wealth Management. He says that the recent private placement of these bonds was primarily to institutions and not HNIs. Even if these issues finally make their way into the primary market through a public issue, he feels that it may not kindle much interest.

“Tax-free bonds saw maximum inflows when the rates were above 8 per cent. HNIs are not waiting that eagerly for these issues because there is not that much of a pent-up demand. HNIs have already invested in tax-free bonds.

“They are trying to allocate more to other asset classes. People who do not have tax-free bonds, and want to invest, can do so from the secondary market,” he says.

Alternative to primary issues
The secondary market offers another avenue to buy bonds. While most HNIs prefer to hold bonds till their maturity, switching to other bonds may at times provide better returns.

Apart from the coupon rate, investors also benefit from capital gains if interest rates move south. So just like equities, there is a secondary market for bonds too, where you can trade. But how do you access it?

Well, if you thought that bonds can be traded on the exchanges under an order matching system, it’s not quite so simple. While you can see at what price older bonds are trading at in the secondary market, they are only indicative prices.

Owing to very thin liquidity in these bonds, most of the times actual trades fall through at negotiated prices, which are different from quoted prices. And this is where a broker steps in.

Trading in the secondary bond market happens over the phone through a broker. The secondary market lacks liquidity as well as transparency in pricing. An investor who wants to buy places an order with the broker, who then finds a seller and negotiates the price for you.

“Currently HNIs who want to pick up tax-free bonds from the market have a good number of avenues. While these bonds are coming into the primary market by offering about 7.1 per cent coupon for a 10-year tenure, in the secondary market, these bonds are available at 7.2-7.3 per cent yield to maturity (YTM), “ says Shanker.

The YTM equation
The coupon rate of a bond issue that opens in the primary market is clearly the annual rate of return. This helps you decide whether you should lap up these bonds. But in the secondary market, the coupon rate alone is not the deciding factor. This is because the bond in the secondary market may trade below or above its issue price.

Thus, the return on the bond (YTM) is the effective return you can earn by way of interest and repayments by buying it at its current price.

YTM measures your actual returns if you invest every coupon payment from the bond at a constant interest rate until the bond’s maturity date. While in reality this is not possible, we make an assumption that all coupon payments are reinvested at the same rate as offered by the bond.

The 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. As bond prices fall, yields rise. There is an inverse relationship between the two.

Should you buy now?
Usually, in a rising interest rate scenario, the rates on new bond issuances are much higher than those issued in the past. Thus, as the price on existing bonds falls, there is an opportunity for an investor to invest in the secondary market. In a falling rate scenario, prices of bonds quote at a premium. Currently we are in a downward rate cycle.

Shanker points out that even though there are opportunities in the secondary market, HNIs are adopting a wait-and-watch approach.

“The RBI’s main aim is to anchor inflation expectations at a low level, in a country that has been used to high inflation. Once everyone in the economy believes that inflation will be low at 4.5-5 per cent for a long time, then 7-7.4 per cent yield looks great. People are trying to re-adjust to lower rates, because only last year, the yields were 8 per cent.” But aside from looking at attractive yields, investors also need to consider the rating of such bonds. The recent downgrading of Amtek Auto bonds by rating agencies is a case in point. It is best to stick to AAA or AA+ rated bonds for now.

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. So keep a close watch on volumes.

Other bonds
Aside from tax-free bonds, there are other bonds that HNIs are currently watching out for. “HNIs, for instance are looking at reputed companies issuing preference shares, which offer 8+ per cent rates. They are also looking at real estate NCD funds, which give gross yield of 18-20 per cent and post tax return of about 13 per cent,” says Shanker. There a few like SBI and IOB Basel III perpetual bonds too that are quoting at a discount, he adds.

But, remember, if you buy in bulk you will get a better opportunity in the secondary market.

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