Due Diligence. Picking tax-free bonds from secondary market

Tax-free bonds issued in recent times were a large hit among investors wanting stable return with low risk. While new issuances of these bonds have attracted a lot of interest, awareness about the secondary market for these bonds is quite low.

Both the BSE and the NSE facilitate purchase and sale of tax-free bonds issued by the state owned infrastructure finance companies over the past five years. Currently, some series of the tax-free bonds are available at yield to maturity (YTM) close to G-Sec yields, thus making them a viable option for fixed income investors.

But with the yields having fallen significantly over the past year, there is a possibility of yields bottoming out in the coming months. In this situation, it is important to keep the liquidity of the instrument in mind while making the investment decision, in case you decide to exit to prevent loss of capital.

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 the investor should consider — credit rating, YTM and liquidity.

Those who like to play it safe should pay particular attention to credit rating, for higher the rating, lower the default risk. The tax free bonds issued by NHAI, PFC, IRFC, HUDCO, REC, IIFCL, JNPT, NHPC, NTPC, NHB and NABARD are currently rated at the highest notch of ‘AAA’ by credit rating agencies. Tax-free bonds issued by IREDA hold ‘AA+’ status while those issued by Kamarajar Port and DCI hold rating of ‘AA’.

It has been observed that liquidity in most of the tax-free bonds series allotted to the retail segment witnessed fall in volume since listing. It implies that most investors prefer to hold these bonds for a longer period or till maturity.

Despite this, there are many bonds traded with ample liquidity since listing, from which you can choose.

Data compiled by HDFC Securities shows that out of the 193 series of listed tax-free bonds, more than 14 bond series are traded with daily average volume of at least 1,000 units in the last one-month period, either on the BSE or the NSE (as on November 29, 2016).

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

There was a sharp fall in the yields of tax-free bonds over the past year; down from an average of 7.35 per cent a year ago to the current levels of 6 per cent. The falling trend in the yields of tax-free bonds can continue in the immediate future due to easing liquidity condition, favourable policy actions and increased appetite for safer investment avenue.

The data shows that there are 10 bonds series trading with YTM of 6 per cent and above with good liquidity. The current yield of 6 per cent translates into 8.7 per cent of pre-tax yield; which is good enough for retail investors wishing to deploy their money at this point of time.

But investing in tax-free bonds with yield below 6 per cent may not be a good idea, as the downside could be limited from there. If we look at the movement of G-Sec yields over the past 25 years (yields on AAA rated tax-free bonds are benchmarked to G-Sec yields), yields bottomed at 5.24 per cent in January 2009 and 4.95 per cent in October 2003. Therefore, the bottom could be near for tax-free bond yields too.

Further, alternative investment options such as debt mutual funds score over tax-free bonds, giving you more than 6 per cent post tax.

Those who wish to invest in tax-free bonds at this juncture should consider investing in those that offer good liquidity. The accompanying table gives the list of liquid tax-free bonds.