Stock investors may be celebrating, but even those who invested in tax-free bonds have got reasons to cheer. Taxfree bonds issued in 2013 and earlier this year have churned out terrific returns of up to 25%. The 20-year tax-free bond from the National Housing Bank (NHB), which hit the market on 30 December 2013, is quoting at Rs 6,225, a return of 24.5% on its issue price of `5,000. Other bonds issued around the same time have also given good returns (see table).

A combination of factors has led to the rally in these long-term bonds. First, there is no new supply of tax-free bonds because the 2014 Budget did not allow new tax-free bond issues. Second, the Budget also changed the tax rules for debt mutual funds, which drove more high net worth investors to taxfree bonds. Lastly, the recent fall in inflation have raised hopes of an early rate cut by the RBI and this pushed up bond prices in the secondary market.

Should you sell now?

The 22-24% rise in bond prices may prompt many investors to book profits, but experts think there is still some steam left in these bonds. The September 2014 retail inflation number was down to 6.46%, way below the RBI's target of 8% for January 2015 and close to its 6% target for January 2016.

Wholesale inflation is at a five-year low of 2.38%, raising hopes of a rate cut. "RBI is expected to cut rates or give clear hint about cutting rates from February 2015," says Vikram Dalal, Managing Director, Synergee Capital Services. The Centre's initiatives to deregulate diesel and launch the direct transfer scheme for LPG subsidy, also makes a case for bringing interest rates down.

"This will reduce subsidy by eliminating leakage. And, lower subsidy means less government borrowing and, therefore, lower interest rates," says Dalal. If rates are cut, bond prices will shoot up. Others think that these tax-free bonds are a good way to earn tax free income for retired people. "Retirees who invested for regular tax-free returns should continue holding these bonds," says Suresh Sadagopan, Founder, Ladder7 Financial Advisories. Since the coupon rates are quite attractive, don't sell now.

Higher yield compared to FDs

Though the prices have rallied in the past 10 months, the yield to maturity of most bonds is still above 7%. This makes them attractive for investors in the highest 30.9% tax bracket. "These long-duration tax-free bonds are offering better yields compared to the posttax yields of other options such as FDs," says Dalal. The yield is over 10% for those in the highest 30.9% tax slab.

So, it should be worth considering. Another factor that should attract investors is the long residual period of these bonds. With the economy stabilising, the interest rate structure may remain benign for the next decade. So, it makes sense to invest in these high-yield bonds now.

Don't ignore taxation issues

If you decide to exit now there will be tax implications. Says Dalal: "If you sell before one year, you will end up paying short-term capital gains tax even on the accumulated tax-free interests." Therefore, sell only after completing one year to get long-term capital gains benefit. As there is no indexation benefit available for such bonds, you have to pay 10% tax on long-term capital gains.

What else to look for

In addition to the yield-to-maturity, investors who want to buy from the market also have to look at the credit ratings of these tax-free bonds. Though these offerings are from PSUs and, therefore, the probability of default is low, you should demand higher yield if you are going below the AAA-rated papers.

Go for bonds that are regularly traded. We included bond issues that are at least `500 crore, since it ensures greater liquidity.