As demand rises, tax-free bonds outperform equities

MUMBAI: Tax-free bonds are outperforming even stocks among asset classes as demand surged after the government did away with fresh issues in the current financial year that started from April 1, capping supplies of such securities. Equity and debt products aren’t strictly comparable, but the belief that stocks are getting expensive makes taxfree bonds attractive bets.

Triple-A rated tax-free papers are quoting yields in the range of 7.35% to 7.40% for 10-year maturities and 7.45% to 7.55% for 15 to 20-year segment. These levels were about 8.50% higher than preUnion Budget levels, dealers said sourcing data from NSE and BSE.

Bond yields and prices move in opposite direction. "Investors from FMPs (MF) have shifted to tax-free bonds, which are yielding higher returns," said Deepak Panjwani, head debt markets at GEPL Capital. "Tax-free bond yields are maintaining their downward trend, and, on the other hand, G-Secs are maintaining their upward trajectory." The Nifty was only marginally up by 0.5% between July 9 and August 11.

Demand for these bonds is so high that even on days when yields on government securities rose, the yields on tax-free bonds fell. Some of the most traded papers are of Rural Electrification Corporation, National Housing Bank, National Highway Authority of India and NTPC.

"For an individu al falling under the 30% tax bracket, it still makes sense to invest in those tax-free bonds even at the current yield levels if s he is considering to put similar amount in bank fixed deposits," Anil Re go, CEO of Right Hori go, CEO of Right Horizons, a Bangalore-based firm, said.

To get a post-tax yield at 7.40% just like in tax-free bonds, an investor has to invest in a fixed deposit scheme that offers about 10.57% pre-tax assuming she falls in the 30% tax bracket. None of the banks is probably offering such high rates on term deposits. In 2013-14, the government allowed 13 public sector institutions to raise Rs 48,000 crore through taxfree bonds to meet their investment needs. In the Budget 2014-15, there was no announcement on new issues of tax-free bonds. However, the absence of such an announcement is seen as a positive for existing bonds. A future rate cut could result in higher rates from these bonds.

"Investors who invested immediately after the budget are mostly staying invested, though the investments in taxfree bonds are at a profit now," said Joydeep Sen, senior VP advisory (fixed income) at BNP Paribas Wealth Management. "Even after the rally, other (taxable) bonds are not as attractive as tax-frees, on a net-of-tax basis."

There's potential for capital gains over the holding period in these bonds as and when interest rates come down further.

Existing bond-holders, who have bargained hard to get a better deal, may have gained from secondary market sales, dealers said. Those 10-year bonds were actually sold close to 9% level.