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Tax-free bonds are shooting up





Some of these bonds issued by PSUs have risen 22-24% in the past 10 months.

While long-term debt funds have given good returns, the tax-free bonds issued by PSUs have done even better. Some of these bonds have risen by 22-24% in the past 10 months. Despite the spurt in prices, experts believe these bonds still have a lot of steam left. They expect these bonds to generate better returns in the coming months. Investors who hold these tax-free bonds should not sell now. Others can consider buying them now because despite the rise in prices the post-tax yield is better than that offered by other debt instruments such as fixed deposits and NSCs. On a pre-tax basis, long duration tax free bonds are still offering better yields compared to other options available. For example, the yields to maturity (YTM) for most tax free bonds are close to 7.3% now and this works out to be a pre-tax return of 10.56% for anyone in the 30% tax bracket. Can tax-free bonds generate better returns than other bonds? Yes, because the new government has choked the supply and disallowed any more such issues. These tax-free bonds are in high demand from HNIs, especially after the change in the tax rules for debt funds. These bonds enjoy a tax advantage over debt funds. Debt funds must be held for at least three years if the investor wants his gains to be classified as long-term capital gains. But the tax-free bonds are eligible for long term capital gains after one year.

Besides, the interest from these bonds is tax free. On the other hand, the gain from the mutual fund is taxed as capital gains. To reduce the capital gain impact here, you can sell the bond after receiving the tax free interest. However, one disadvantage is that these tax-free bonds are not eligible for indexation benefit.

The first thing to look for in a tax-free bond is its yield to maturity (YTM). Also look at the credit rating. Though these bonds are from PSUs and the risk of default is very low, you should demand higher yield if you buy anything rated below AAA. Also look at the issue size. Go for bonds with a larger issue size because they are more liquid.

 

Medium or long-duration bonds

To gain from the bond rally, move out of short-term debt funds to long-duration funds. The returns from short duration funds will fall if there is a rate cut. These funds will be forced to invest in new investments and maturity amounts of old investments at lower rates. Long-term debt funds, on the other hand, will generate fabulous returns in a falling interest rate scenario. With the current coupon rates of long-duration papers with over 10-year maturity at 8.5-9%, these funds should be able to generate similar returns even if the rate structure remains stagnant for the next one year. Capital gains due to the fall in interest rates will also add around 5 percentage points to the returns if we assume a 50 bps cut. However, long-duration funds are also more volatile. If your risk appetite is low, you can consider medium-duration (average maturity of 5-10 years).

Gilt or corporate bonds

Government securities are more sensitive to interest rates and, therefore, will be the first to move up when there is a rally after a rate cut. They are also free from de fault risk. Corporate bonds, on the other hand, generate better yields. However, experts say income funds are better because the fund managers can include both gilt and corporate bonds in the portfolio. Income fund managers can play the credit spread. Credit spread refers to the yield gap between gilt papers and AAA rated corporate bonds.

Dynamic bond funds

Selecting the right duration and exiting at the right time, however, may not be easy for all retail investors. If you think you may not be in a position to take a call on interest rates, go with dynamic bond funds. Here, fund managers will be taking the call on your behalf. "Dynamic bond funds are a better option because static portfolios won't work in a volatile interest rate regime. Actively managed debt funds should do better than fixed duration funds in a 3-5 year time period. In recent months, fund managers of dynamic bond funds have increased the average maturity of their portfolios. From two years earlier, the average maturity is now around six years.

Selecting funds

To select good schemes, always stick with large-sized funds. The market lot size in the wholesale debt market is very high (around `5 crore) and a smaller fund may not be able to fully capitalise the emerging opportunities in the market. Also, smaller funds may face a tough time if there is sudden redemption pressure. The fund manager will have to resort to distress selling, which will hurt the fund's NAV. Also, make sure that the portfolio is not into lower rated bonds. Some fund managers try to improve their returns by including low-rated corporate bonds that offer higher yields. Stay away from such funds.


 

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