Portfolio

Four tax-free bonds for you, in 2020

Dhuraivel Gunasekaran BL Research Bureau | Updated on December 25, 2019 Published on December 25, 2019

If you’re a conservative investor or retiree looking for a regular income, consider buying these bonds from the secondary market

Over the past two years, credit quality issues in debt instruments such as rating downgrades and default in repayment have haunted 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. Mutual funds, insurance schemes, NPS (National Pension System) and EPFO (Employees’ Provident Fund Organisation) were among those that took a hit.

Capital safety has now become a prime concern for retail investors. Investors looking for debt instruments that provide capital safety and decent returns can consider tax-free bonds available in the secondary market. Since these entities are backed by the government, investments in their tax-free bonds enjoy capital safety.

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

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. Going by the data compiled by HDFC securities, there are a handful of tax-free bonds with good credit rating that trade with relatively higher volumes and also offer reasonable YTMs (yield to maturity) in the secondary market. These include the series of HUDCO, IRFC, PFC and NHAI bonds. These are good options to consider for fixed income investors at this point in time.

How to buy

Both the BSE and the NSE facilitate the purchase and sale of tax-free bonds. They are listed and traded in the cash segment along with the 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.

Eye the yields

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.

For instance, the HUDCO N3 series (ISIN INE031A07832), with a coupon rate of 8.1 per cent and residual maturity of 2.2 years, trades with a YTM of 5.8 per cent on the NSE. Since the interest paid by tax-free bonds are exempt from income-tax, the current yield of 5.8 per cent translates to 8 per cent pre-tax yield for investors in the 30 per cent bracket. This rate is relatively higher than those offered by bank fixed deposits currently.

It is to be noted that the recently launched Bharat Bond ETF, a passively managed debt exchange traded fund that tracks the index constituting the AAA-rated bonds issued by PSUs, has offered 6.83 per cent (pre-tax yield) on its bond series maturing in the next three years and 7.75 per cent in the bond maturing in the next 10 years.

Bharat Bond ETFs are treated at par with debt mutual funds for tax purposes, wherein the sale of units after 36 months from the date of purchase qualifies for long-term capital gains tax at 20 per cent with indexation.

The YTM offered by the tax-free bonds with short residual maturity of around two or three years is higher than the yield offered by the Bharat Bond ETF maturing in three years.

Liquidity matters

The liquidity or the traded volume is important while buying and selling the bonds in the exchanges. Higher liquidity enables buying and selling of bonds at the desired price and quantity.

The short-listed bonds series (see table) issued by HUDCO, IRFC, PFC and NHAI are traded with relatively higher liquidity. For instance, the daily average traded volume in the HUDCO N3 series over the past one month was 1,186 units.

What’s on offer

We have short-listed two series of tax-free bonds (one maturing in 2-2.5 years and another in 11-14 years) each from the above mentioned issuers. It is advisable to lock in the money for the short term at this juncture considering the prevailing low interest rates. One can expect a higher yield once interest rates increase. Given that, the tax-free bonds with a residual maturity of 2-2.5 years are traded with a YTM of 5.7-5.9 per cent currently.

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 per your tax slab. If you sell after 12 months, tax has to be paid at flat rate of 10 per cent. There is no indexation benefit available.

About the issuers

HUDCO is a wholly government-owned entity, providing loans for housing and urban infrastructure projects in India. It has been conferred the status of Miniratna (category-I public sector enterprise) by the Centre. It focusses on funding the housing needs of economically weaker sections and low-income group category, along with funding non-commercial urban infrastructure.

PFC, established in 1986, is one of the government-owned financial institutions that provide financing exclusively to the power sector, including for thermal, hydro, nuclear, wind and solar power generation; transmission and distribution; and renovation and modernisation of existing projects. The government supports the company financially and operationally in various ways, including conferring special status to raise capital gains tax-exemption bonds.

IRFC, the financial arm of the Railways, functions under the Ministry of Railways. It derives substantial business and financial support from the Centre as the latter owns it 100 per cent. The Centre has been infusing equity capital at regular intervals to support IRFC’s capital structure.

The Centre also owns a 100 per cent stake in NHAI. The company receives continuous support from the government in the form of capital grants, allocation of cess funds, additional budgetary support and guarantees for its market borrowing programmes.

Published on December 25, 2019
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