For conservative investors and retirees, tax-free bonds are a good bet

Over the past year or so, many banks have slashed interest rates on the fixed deposits (FDs) they offer, due to the successive repo rate cuts by the Reserve Bank of India (RBI). For instance, State Bank of India (SBI) now offers just 4.9 per cent for 1 year to less than 2 years tenure, and 5.4 per cent for tenures of 5 years up to 10 years.

Also, over the past few years, credit quality issues in debt instruments such as rating downgrades and default in repayments have given trouble to many fixed income investors. Such credit events led to a sharp erosion in the value of the investment products that held these distressed assets in their portfolio. So, capital safety has now become a prime concern for many retail investors.

Given the low interest rate regime, investors looking for debt instruments that provide returns relatively higher than bank FD returns, and also capital safety can consider tax-free bonds available in the secondary market.

Conservative investors and also retirees in the highest tax bracket looking for a regular income on a yearly basis can consider buying these bonds from the secondary market.

A total of 193 series of tax-free bonds issued by 14 infrastructure finance companies from FY12 to FY16 are listed on the bourses. They are traded in the cash segment on the BSE and the NSE. These tax-free bonds were issued by public sector undertakings and public financial institutions that are backed by the government of India. Hence, the investments made in these tax-free bonds enjoy capital safety.

Further, the bonds issued by most of these companies have the highest credit rating of AAA. Instruments rated AAA are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry the lowest credit risk.

Attractive yields

Data compiled by HDFC Securities show that there are a handful of tax-free bonds with good credit rating that trade with relatively higher volumes and also offer reasonable yield to maturity (YTM) in the secondary market (see table). These include the series of PFC, NABARD, HUDCO and NHAI bonds.

For instance, the NHAI NR series (ISIN INE906B07EJ8), with a coupon rate of 7.6 per cent and residual maturity of 10.3 years, trade with a YTM of 4.8 per cent on the NSE. Since the interest paid by tax-free bonds are exempt from income-tax, the current yield of 4.8 per cent translates to 6.9 per cent pre-tax yield for investors in the 30 per cent bracket. This rate is higher than those offered by most bank FDs currently.

Both the BSE and the NSE facilitate the purchase and sale of tax-free bonds. These are listed and traded in the cash segment along with equity shares. Retail investors can buy and sell tax-free bonds through demat accounts.

While investing in tax-free bonds through the secondary market, investors should not just look at the coupon rate and the market price of the bonds. There are three parameters that they should consider — credit rating, YTM and liquidity.

YTM is the internal rate of return earned by an investor who buys the bond today at the market price, assuming that the bond is held until maturity, and that all coupon and principal payments are made on schedule.

HDFC Securities data shows that around 15 series of tax-free bonds were traded with YTM ranging from 4.4 per cent to 4.9 per cent and good daily average trade volumes over the last one month (see table).

Keep in mind that selling tax-free bonds in the secondary market attracts capital gains tax. If you sell them within 12 months from the date of purchase, you will have to pay tax on the gains as per your tax slab. If you sell after 12 months, tax has to be paid at flat rate of 10 per cent; no indexation benefit is available.

Factors to consider

Take into account the credit rating, YTM and liquidity of the tax-free bonds trading in the secondary market