Column

Tax-free bonds are issued by entities such as the National Highway Authority of India (NHAI) and Power Finance Corporation (PFC) as they are important to the government in terms of building the country’s infrastructure. The most recent issues have been from NHAI and PFC. The bonds issued by these entities carry a coupon of 8.2% per annum for a ten-year maturity bond and 8.3% per annum for a 15-year maturity bond.

The bonds are rated AAA by rating agencies and are listed on stock exchanges. The bonds can be traded. The interest paid on the bonds is tax-free though any capital gains from sale of the bonds in the secondary market are taxed on a short-term or long-term basis.

Cost of tax

The cost of the tax is that the bonds, which carry credit risk, is priced better than that of government bonds that are risk-free. The ten-year government bond yield is at 8.4% while the 15-year government bond yield is at 8.6%. The tax-free bonds carry yields of 8.2% and 8.3%, which are 20bps and 30bps below yields offered by similar maturity government bonds, respectively.
Investors are exposed to rating downgrades for these bonds if the credit quality deteriorates. There are concerns on the credit quality of PFC which has high exposure to loss making state electricity boards (SEBs).

Is effective yield the right way to look at tax-free bonds?
Investors get carried away by the effective yield on tax-free bonds. The effective yield is calculated as follows:

Effective yield = coupon rate/ (1-tax rate). Hence, for a coupon of 8.2%, an investor in the 30.9% tax bracket has an effective yield of 11.86%. The cash flow in the hands of the investor is only Rs 8.2 for every Rs 100 invested in the bonds, and the reason the yield is shown higher is due to the tax rate. Change in tax rate will change the effective yield on the bonds.

Who should invest in tax-free bonds?
Effective yield is only relative in nature, not absolute. If the comparison is between investing in a ten-year fixed deposit of an AAA-rated bank at 8.2% which is taxable and investing in a ten-year maturity tax-free bond at 8.2%, then effective yield can be used as a measure for comparison. Investors can substitute tax-free bonds for fixed deposits as post-tax return is much better on tax-free bonds.

Investors wanting to park surplus funds in an asset that will give them an absolute return of 8.2% every year for ten years, or 8.3% every year for 15 years, irrespective of the returns available elsewhere, can invest in tax-free bonds. In such cases investors are content with the returns offered and have surplus money that can be locked in for ten or 15 years.

Who should not invest in tax-free bonds?
Investors who are looking at capital gains from selling the bonds down the line should not invest in tax-free bonds. Tax-free bonds are not traded as much as taxable bonds, leading to lack of correct price discovery. Investors can lose as much as 2% in paying bid-ask spreads while transacting in tax-free bonds and this leads to lower returns.

Investors who do not have a long-term investment horizon should not invest in tax-free bonds.

The writer is the editor of www.investorsareidiots.com, a website for investors