Savvy investors seeking higher-than-average returns from fixed income instruments are buying tax-free bonds from the secondary markets. These risk-free bonds floated by various government entities in the last four years could fetch as much as 2%-5% more than bank fixed deposits in a falling interest rate scenario.

Tax-free bonds are traded on the stock exchanges just like shares. Wealth managers said the appetite is strong for most tax-free bonds but higher for the ones issued earlier this year because of higher yields.

"Certain series of Tax free bonds issued in March such as HUDCO, NHAI, NABARD are available in the secondary markets and offer a yield of 7-7.05%. This translates into a pre tax yield of 10.5%," said adds Vikram Dalal, Managing Direct, Syngergee Capital.

For instance, the 7.69% NHAI - NE, trading at Rs 1057, will pay an annual interest of 7.69% in October every year. It has a tenure of 15 years.

Investors eyeing tax free bonds in secondary markets

Compared to this, a fixed deposit from State Bank of India, which pays a maximum of 7.5% interest per annum, would yield a post-tax yield of 5.18% for an investor in the highest tax bracket. Tax free bonds score over fixed deposits from banks, especially for those investors in the high tax brackets.

Some investors are in it to bet on falling interest rates

"In a scenario where interest rates are headed down, you stand a chance to make capital gains as well," said Dalal

Longer the tenure of the bond, the higher could be the capital appreciation. If interest rates were to fall by 50 basis points, investors can hope for a capital appreciation of 2.4-3% on a 10-year bond, while they can pocket a gain of 4-5% for a 20-year bond.

Tax free bonds are also witnessing higher trades as no fresh supply is expected this year. "No tax free bonds have been announced by the government in the budget for this financial year," says Ajay Manglunia, Head (Fixed Income), Edelweiss Capital.

So, if investors want to invest in these bonds, the only way they can get these bonds now is to buy them from existing investors.