Should retirees invest in tax-free bonds in secondary markets?

The debt asset class is turning attractive now, with interest rates peaking and the financial markets approaching a possible rate cut. This makes it a good idea to lock in the current higher yields that are available on quality debt instruments.

Tax-free bonds that were launched in the past are now available for buying and selling in the cash segment of exchanges, such as the BSE and the NSE. A few of them are being actively traded and available at attractive yields.

They have been a lucrative option for investors looking for capital safety and regular income -- like retirees in higher income-tax (I-T) slabs.

What are tax-free bonds?

A total of 14 state-owned infrastructure finance companies, like the National Highways Authority of India (NHAI), Indian Railway Finance Corporation (IRFC) and Power Finance Corporation (PFC), had issued secured tax-free bonds between financial year 2012 and 2016.

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These bonds were issued with the tenure of 10, 15 and 20 years, with interest paid annually. Most of them have been rated at the highest ‘AAA’ grade by credit rating agencies.

An attractive option for conservative investors

Interest earned from these tax-free bonds is entirely tax-free. Since these bonds were issued by public sector undertakings and financial institutions that are backed by the government of India, they are largely safe.

These make tax-free bonds a compelling option for investors looking for capital safety and regular income like retirees.

Factors to consider while buying bonds on exchanges

All the series of tax-free bonds have been listed in the cash segment of the BSE and the NSE. Of the 193 series of tax-free bonds, 92 series have matured, and the remaining are available for trading on the exchanges with a residual maturity of up to 11.4 years.

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It is always better to choose bonds that are traded with high liquidity and yield to maturity (YTM). You can buy the bonds at the desired price that are traded with high liquidity. Else, the yield will ultimately be lower due to the increased acquisition cost in illiquid bonds. YTM is an assumed annualised return an investor can expect to receive from a bond if they hold it until it matures.

Data compiled by HDFC Securities shows that while most of the series have low volumes, around 20 series of tax-free bonds are traded with relatively higher YTM and reasonable liquidity in the exchanges.

For instance, The REC bond series ‘871REC28’ paying 8.71 percent annually, issued 1n 2014, were traded at the YTM of 5.6 percent with the daily average volume of 1,158 units over the last one month.

Attractive yields

Acording to HDFC Securities data, there were 15 series of tax-free bonds, traded with relatively higher YTM between 5.5 percent and 5.9 percent.

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This can be compared with the yields of corporate bonds and banks fixed deposit rates.

Currently, AAA-rated corporate bonds provide yields of around 7.3 percent while SBI’s FD schemes for five years offer up to 6.20 percent interest rate per annum for senior citizen depositors.

However, since the interest is taxable in corporate bonds and bank FDs, the post-tax returns come down to around 5.1 percent and 4.3 percent, respectively, for investors in the 30-percent tax bracket. Hence, tax-free bonds are attractive avenues for investors in the higher tax bracket.

Why is it the right time to buy tax-free bonds?

It is always a good time to buy tax-free bonds since there is no investment limit (by investing in multiple ISINs (International Securities Identification Numbers) and it saves tax, says Suresh Darak, Founder & Director, Bondbazaar.

Currently, expectations of interest rate cuts have put debt instruments in a good position. Experts anticipate that the Reserve Bank of India (RBI) will likely initiate rate cuts in the next 6-12 months.

“Central banks from developed markets and emerging markets have started cutting rates. We believe that the US Fed may start cutting rates from September. We anticipate rate cuts from RBI in 6-12 months, of up to 0.50 percent,” said Devang Shah, Head-Fixed Income, Axis Mutual Fund.

Bond prices and interest rates have an inverse relationship. So when interest rates fall, bond prices go up.

“With interest rates peaking and as we approach a possible rate cut in the US, there’s anticipation that rates may begin to decline. Additionally, we expect that rate cuts will eventually follow in India as well, as RBI aligns its monetary policy to support economic growth while inflation stabilises. This could make locking in the current yields on tax-free bonds particularly advantageous,” said Vishal Goenka, Co-founder of IndiaBonds.com

Limited availability

Moreover, since no new tax-free bonds are being issued, their limited availability in the secondary market makes these bonds a rare and valuable addition to portfolios.

Lower interest rates generally lead to an increase in bond prices, which further enhances the attractiveness of holding these bonds as part of a diversified investment strategy.

However, investors should carefully consider their risk profile and investment objectives before investing. “It is always advisable to consult a financial professional to ensure that tax-free bonds align with their overall financial plan,” Goenka suggested.

Investors have to consider buying these bonds with residual maturities matching their time horizon. It makes sense holding them till maturity. You need demat accounts to buy these tax-free bonds in the stock exchanges.

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