Investments in tax-free bonds in the past year would have fetched you as much returns as mid and small-cap equity schemes -the best performing mutual fund category. The bonds have returned 25-27% on an annualised basis led by a sharp rally in the bond market of late.
Between January and March, Nabard, Hudco and IRFC, among others, had come out with tax-free bonds. These firms raised money at rates between 7.6% and 7.7%.

“The returns comprise two components ­ interest income on the bonds and capital appreciation,“ says Vikram Dalal, managing director, Synergee Capital. Bond prices appreciated as interest rates cooled off and liquidity improved.

The benchmark 10-year fell from 7.5% in March and currently trades at 6.73%, leading to a sharp appreciation in the prices of these bonds.

Even after this sharp appreciation, wealth managers advise investors to hold on to the bonds or even add more. Firstly , there will be no fresh issue in this financial year in the primary markets. Secondly , these bonds at the current market prices give investors a yield between 6.4-6.45% per annum. As inflation cools off and remains low, interest rates are further expected to cool down, which could lead to a even more capital appreciation from these bonds.

“The 10-year benchmark will come down to levels of 6% over the next 12 18 months. This could result in investors getting a return of 14-15% if they buy tax-free bonds at these levels,“ says Dalal. He expects the yields on these bonds to move down to touch 5.50-5.75% in a year's time. Dalal says he is reminded of the years 2004-05 and 2005-06 when 6.75% UTI US 64 bonds and 6.60% UTI ARS bonds were trading at a yield of 5.00 ­ 5.25%.

These bonds score over traditional instruments such as fixed deposits, especially for those in the higher tax bracket, even if one does not consider capital gains. A 10-year fixed deposit from SBI , for instance, fetches 7.25% annualised returns. After paying a 30.9% tax, your post-tax returns work out to 5.01%.

Tax-free bonds with a tenure of 15 years can give you a return of 6.4% to 6.5%. In addition, you have an opportunity to pocket capital appreciation when interest rates start moving down. These bonds carry negligible risk as they are AAA rated and issued by government-owned companies. These bonds have tenure of 15 years and have no put or call options.