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Tax-free the new mantra as bond yields fall

With bond yields falling, it could be a good time to invest in some long-term debt products like tax-free bonds.

As per data from brokerage firm Bonanza Portfolio, Hudco’s tax-free bonds, which were issued in May 2012, have given total annualised return of almost 8.27% (as on December 2).

Similarly, Rural Electrification Corporation (REC) tax-free bonds have give an annualised return of 15. REC bonds were issued in March this year.

Total absolute return from Hudco and REC stand at around 23 and 10.50%, respectively. The coupon or interest income from these bonds stand at 8.20 to 8.40%.

Hiren Dhakan, associate fund manager, Bonanza Portfolio adds that National Highway Authority of India’s (NHAI) bond is currently trading at Rs 1,124. These were issued in January 25, 2012 and has its next interest payout on October 1, 2015.

“That’s a huge premium today considering interest will be paid in October 2015. Despite all the past interest payouts, if the bondholder sells the bond, it would result in an absolute return of 12.4%. The bonds are trading at a premium as yields have fallen, discounting for a probable cut in interest rates,” he explains.

In the last six months, yields on 10-year Government Security bonds have fallen 58 basis points or 0.58% from 8.645% in May end this year. Yields on these bonds touched a 16-month low of 8.09%.

Dhakan believes individual investors who missed the bus could park some funds in these bonds. Additionally, prices of these bonds would run up once RBI cuts interest rates in the next 1-2 quarters. Bond prices are inversely proportional to interest rates. Given there is only expectation of a rate cut and no clarity on it on the exact timeline, one will need to be sure if they intend to buy and hold these bonds or not.

Experts, however, are also advising a bit of caution for novice investors. Vidya Bala, head – research of FundsIndia.com says, “If an individual investor is looking for capital appreciation then he / she should be a savvy investor who knows when to exit as it would mean taking a call on interest rates.” Otherwise, she feels, tax free bonds are not suitable enough for retail investors as now these will need to be bought in the secondary market. Secondly, the secondary corporate debt market is not very liquid and trading in bonds are few and far between.

Agrees Dhakan, “Only those investors should buy these bonds who have an investment horizon of more than one year, in case RBI delays rate cuts.”

A simpler solution for individuals would be to take exposure in debt mutual funds — income funds. Many of these have taken position in the long term government securities, says Bala. This would also diversify your debt portfolio into various bonds across maturities. As per mutual fund rating agency, Value Research, income funds have returned nearly 12% in the last one year and 6.50% in the last six months.

Feroze Azeez, executive director – Investment Products (Private Wealth Management) at Anand Rathi Financial Services has another strategy for slightly savvy investors. “Existing tax-free bonds are trading at yields much below their coupon, and have delivered good capital gains. For instance, a 10-year tax-free bond issued at a coupon of 8.14% in 2013 is currently trading around 7.20%,” he says.

He further explains by redeeming your investment in tax-free bonds invested in 2013 or earlier and investing the proceeds in a high quality portfolio of mainly AAA rated papers (currently offering a yield of 8.6%), you would make a post-tax, post-expense Internal Rate of Return (IRR) of 8.59% for the next three years (higher than 8.14% coupon).

Further, taking into account the capital gain you make on your original investment, this strategy would generate an IRR of 10% since inception, that is, between 2013 and 2017. The additional earning of 1.85% in the initial four years would mean a compounded additional return of 7.6% for four years.

If you stay invested in the tax free bond, the bond would have to fall by around 90 basis points from current levels in next three years to generate a 10% return.

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