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Tax Free Bonds are still better than Bank Fixed Deposits
The high-yielding, tax-free bond issues came to a halt with the end of the financial year 2013-14. Since the supply has dried up after March, the secondary market prices have started firming up. Most tax-free bonds have gone up by 2-3% during the past week. The fear that the new government at the Centre may not allow tax-free bond issues in 2014-15 is also pushing the prices up. Even if the new government decides to have a go, they will not hit the market in a hurry. If new, tax-free bonds are allowed in the July budget, a few months will go in firming up the procedure. So, they are expected to hit the market only by the end of 2014-15.
The expected fall in interest rates also makes the wait for new bonds risky. This is because the coupon rates of the new bonds may be significantly lower compared to the recent issues. It's also noteworthy that tax-free bond issues had failed to collect money in 2012-13 because the rates offered were very low, that is, in the range of 6.9% to 7.4%. However, the jump in government of India bond yield helped generate good coupon rates in 2013-14, making the tax-free bond issues a thumping success. Such high yield won't be there in the future for a unique asset like tax-free bonds. The RBI has left all key rates unchanged in its policy review meeting on 1 April and is expected to go for a cut if inflation continues to move down. This would impact the market-determined government of India bond rates. With a further fall in consumer price inflation, the 10-year G-sec yield should go down by at least 25 bps in the next 6-9 months.
Since the new tax-free bond yields will be linked to the sovereign yield of similar maturities, the trend will be visible in the existing listed bonds as well. Therefore, the secondary market prices may continue to move up if there is an expected fall in sovereign yield, making it an attractive bet now. Whoever missed the tax free bond issues should consider buying from the secondary market. Going ahead, it may be available at a higher price. Though there is a trading possibility to gain from the expected price rise, experts caution not to speculate on tax-free bonds. There is a possibility for capital gains, but don't bet on it. Treat it as an additional bonus.
Compare yields
Identifying the bonds you want to buy from the secondary market is easy. All you need to do is to compare the yield to maturity. Tax-free bonds still offer good yield compared to other taxable long-term investment options, including bank FDs. Since most banks are offering 8.5% for the 10-year taxable FDs, the rates offered by tax-free bonds are attractive even for non-taxpayers.
However, the government's frequent change of rules has complicated matters. For example, there was no yield differential for the issues launched in 2011-12, but the issues hitting the market during 2012-13 had the step-down clause, where buyers from the secondary market would get lower coupon rates compared to the original investors (we used the lower rates for comparing yields). The rule was changed again for 2013-14 and, this time, the retail investors from the secondary market were allowed to get the initial coupon rates. According to this rule, you will be treated as a retail investor if the face value of your holding in any of these instruments is 10 lakh or less at the time of interest declaration.
Rating matters
While most tax-free bond issuers are rated AAA, Hudco and Ennore Port are rated AA+ and AA, respectively. Should you avoid these lower rated papers? May be not. These are top-notch PSUs and what matters is the yield you get. So, you can go for them if the yield is higher than their AAA rated peers. The lower rated issuers were even allowed to offer higher coupon rates at the time of launch. While Hudco was allowed 10 bps more compared to AAA rated bonds, Ennore Port was allowed 20 bps more. Similar coupon differentials remain in secondary markets and investors buying into these should insist on a higher yield.
Don't ignore volume
Though you should buy them with the intention of holding till maturity, you may be forced to sell at an earlier date. So, the traded volume is another important factor you must keep a close watch on. However, that will not guarantee high volumes in the future. "Go with instruments that have a high issue size because they tend to have a higher traded volume," says Kothari. We added instruments that had an issue size of at least 500 crore and are traded frequently with reasonable volumes on the table.
Tax implication
Just because you are buying tax-free bonds from the BSE/NSE, don't think that these will be treated as equity. These are debt products listed on the exchanges and you will have to pay tax accordingly. This means that any short-term capital gain, where the holding period is less than a year, will be taxed at your slab rate. Since it bears interest, investors will not get indexation benefit on these bonds. So, 10% will be the applicable tax rate for long-term capital gains.
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