Those who have invested in tax-free bonds during the primary issue have a reason to smile. The prices of the tax free bonds which are actively traded in the secondary market on BSE and NSE have grown significantly and now yield double-digit gains.

For instance, the series NTPC N6, which was launched during December 2013 with a face value of ₹1,000 and coupon rate of 8.91 per cent, is now trading at the price of ₹1,360 on NSE; the annualised returns (internal rate of return) of the series has touched 15.3 per cent. Similarly, NHB bonds that launched during January 2014, bonds that Nabard launched during March 2016 and REC bond launched during January 2014 have registered 14.1, 16.8 and 13.1 per cent annualised returns, respectively, since their launch.

However, the rise in prices has resulted in fall in yields of the bonds for investors who want to buy it now. Yet, considering that the interest is tax-free, these instruments still score over other options such as fixed deposits from banks and NBFCs. Interest rates on fixed deposits have dropped sharply and their post-tax returns now are much lower than the yields on tax-free bonds.

Yields still competitive When an issue opens in the primary market, the coupon rate on the bond is clearly stated, which is the annual rate of return. But in the secondary market, the coupon rate does not matter.

This is because the bond in the secondary market may trade below or above its issue price. What matters is the yield-to-maturity (YTM).

YTM is the internal rate of return earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments are made on schedule. YTM is calculated by arriving at the discount rate, which equates the sum of all future cash flows from the bond (interest and principal) to the current price of the bond. This can be done with the help of a financial calculator or excel sheet.

While YTM is an important factor to consider, investors should pay attention to credit rating. The higher the rating, the lower the default risk. The tax free bonds issued by NHAI, PFC, IRFC, HUDCO, REC, IIFCL, JNPT, NHPC, NTPC, NHB and Nabard are currently rated at the highest notch of ‘AAA’ by credit rating agencies. Tax-free bonds issued by IREDA hold ‘AA+’ status while those issued by Kamarajar Port and DCI hold rating of ‘AA’.

Besides, liquidity is also crucial, especially when you want to sell the bonds before maturity to lock into profits or to meet a big expense or if you want to exit to prevent loss of capital in bad times. Data compiled by HDFC Securities shows that out of the 193 series of listed tax-free bonds, only 14 bond series are traded with daily average volume of at least 1,000 units in the last one-month period, either on the BSE or the NSE (as on September 20, 2017).

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

The highest YTM currently available is 6.13-6.17 per cent. In comparison, a fixed deposit offers a maximum of 6.75 per cent today on deposits over five years. But since interest is taxable, post-tax returns go down to 6 per cent, 5.4 per cent and 4.7 per cent for the 10, 20 and 30 per cent brackets, respectively.

How to buy Both the BSE and the NSE facilitate 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 the Demat account. Keep in mind that selling tax free bonds in the secondary market attracts capital gain tax.

If you sell these tax free bonds within 12 months from the date you have bought, then you will have to pay tax on the gains as per your tax slab. If you sell after 12 months, then tax has to be paid at flat rate of 10 per cent. There is no indexation benefit available.

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