Comment

The government gives tax-free status to bonds issued by public and private sector enterprises, but it does not guarantee the bonds.

Investors have to differentiate between ‘tax-free’ and government guarantee, and this difference gets muddled in the selling and distribution of tax-free bonds.

Investors wrongly believe that tax-free bonds enjoy credit risk-free status. They don’t see the possibility of a tax-free bond issuer defaulting. Not every issuer will default, but investors should price in credit risk before investing.

Infrastructure bonds are given tax-free status in order to encourage flow of funds to the infrastructure sector. The sector, however, is fraught with risks as seen in the woes of the power sector and its lenders (read the PNB review below). Lenders are facing a huge write-down of loans due to the poor financial state of the borrowers.

Similarly, other projects, including roads, are facing delays in land acquisition, policy changes and such problems, and lenders see project costs rising consequently. Borrowers have no means to service the loans as the projects have not taken off.

Lending to the infrastructure sector in the current environment carries more risk than lending to, say, the retail sector or to the auto ancillary sector. Hence, in a sense, investors are taking on the risk of the infrastructure sector. The tax-free nature of the bonds clouds the risk of lending to the infrastructure sector. The risk is not priced in accordingly in the coupon rate of the bonds.

Public sector enterprises issuing tax-free bonds have the benefit of the government’s support if they come under stress. As seen in the case of Air India, even government support will not work when the losses go out of hand.

Air India has to issue bonds with explicit guarantee by the government for investors to buy the bonds. Private sector enterprises issuing tax-free bonds do have government support in times of stress and will face difficulties servicing loans if losses go out of hand.

Investors must do their homework on the credit quality of the issuer before investing in tax-free bonds. The financial health of the issuer and the ability of the issuer to service loans through cash flows rather than issuing fresh loans, are important factors in judging the credit quality of the issuer.

Government support helps, but a government that is itself unable to manage its finances does not add much comfort to the investor. The investor may be protected on the credit but will not be protected on interest rate risk when rates rise due to poor government finances. There is no free lunch in tax-free bonds.

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