Tax benefits do not appeal to mutual funds. It follows, therefore, that they consciously invest in tax-free bonds with an eye on the falling rate cycle in the country
Investments in tax-free bonds appear to have come good for mutual funds and corporates, as lack of fresh issuances whetted demand from investors eyeing tax benefits in the lead up to the fiscal closing.
The primary market for tax-free bonds was insipid in the past fiscal, with bonds outstanding at over Rs 150,000 crore and hardly any issuances. Squeezing supply further, there was no announcement for fresh issuance of tax-free bonds in the last Union Budget.
However, the secondary market has remained liquid, with market activity tripling in calendar 2016 to Rs 44,968 crore from Rs 15,564 crore the previous year, as the following table shows. And in the first two months of this year, trades amounted to Rs 11,000 crore.
The data suggests mutual funds have been one of key trading participants in tax-free bonds, which saw a spurt in CY2016. High net-worth individuals (HNIs), banks and corporates are expected to have been among the buyers.
Investor interest in such bonds is generally on account of the additional post-tax return, though these papers also offer higher liquidity (compared with fixed deposits, which cannot be traded) and safety (since these are mostly issued by PSUs). For instance, in the highest tax bracket, the post-tax yield on a 10-year AAA corporate bond is 5.32% (assuming 30% tax rate and pre-tax yield of 7.60%), whereas that on the 10 year tax-free bond is 6.2552%).
But the tax benefits do not appeal to mutual funds, which have a pass-through structure. It follows, therefore, that mutual funds had consciously invested in these bonds with an eye on the falling rate cycle in the country, and are selling out as the rate cycle flattens with an upward bias.
Interest rates have seen two cycles where yields have fallen sharply. In 2014, yields on G-Secs and corporate bonds fell 1.13% and 1.04%, respectively, whereas that on tax-free bonds fell 1.36%. Similarly, over the past year, the 10-year G-Sec and corporate bond yields have fallen 57 and 51 basis points (bps), respectively, while the yield on 10-year tax-free bonds has eased 85 bps.
This makes tax-free bonds a lucrative investment proposition in the falling rate cycle, given that prices and yields have an inverse relationship. In 2015, when interest rates were volatile, there was not much deviation in the yield movement of all three types of securities, which reflects in the low secondary trade volume of mutual funds.
Secondary market transactions of mutual funds for the past one year were captured and five mutual funds were identified which were active in trading in tax-free bonds. An analysis of 170 secondary transactions done by these five funds showed mark to market (MTM) gains in terms of yield in 90% of the trades. The top five best performers reported MTM gains in the range of 0.81% to 1.16%, while the top five worst performers reported MTM loss in the range of 0.05% to 0.01%.
In the case of SBI Mutual Fund, for instance, based on scores computed using scheme returns, SBI Magnum Balanced Fund and SBI Magnum Income Fund were always in the top five in their respective categories (consistent-debt, balanced, consistent-balanced).These schemes had higher exposure to tax-free bonds compared with their peers, which could be a one of the key reasons for the alpha.
To be sure, tax-free bonds are mostly of long duration, of 10-20 years. As such, in a falling interest rate environment, capital appreciation would be higher for these bonds. A few mutual funds which took a call on investing in tax-free bonds, timed their investments well and were able to generate alpha for their investors through active management.
LOOK BEYOND THE OBVIOUS
- Tax benefits do not appeal to mutual funds (MFs). It follows, therefore, that they consciously invest in tax-free bonds with an eye on the falling rate cycle in the country
- MFs sell out bonds as the rate cycle flattens with an upward bias. Tax-free bonds are a lucrative investment proposition in the falling rate cycle, given that prices and yields have an inverse relationship
- When interest rates fall, yields drop sharply. Tax-free bonds are mostly of long duration -–10-20 years. In a falling interest rate environment, capital appreciation would be higher for these bonds
The writer is senior director, funds and fixed income, Crisil Research
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