Tax-free bonds available in the secondary market score over other debt products, including NCDs (non-convertible debentures) and debt mutual funds, on capital safety and returns.

A total of 193 series of tax-free bonds issued by 14 infrastructure finance companies over a span of FY12-16 are listed on the bourses. They are traded in the cash segment on the BSE and the NSE. Investors can buy and sell such listed tax-free bonds through their demat accounts.

Investors can access the daily traded price and the volumes of the bonds from the BSE and NSE websites.

Prices are dirty

The traded prices of the tax-free bonds displayed on the BSE and NSE websites are ‘dirty prices’ — it includes all accrued interest to date. The bond price without accrued interest is called ‘clean price’.

To understand this, you must know how bonds are priced and how they accrue interest.

When tax-free bonds are issued, the allotments are made at the face value (usually ₹1,000 per unit). Post-listing, the bonds are bought and sold as per the traded price in the secondary markets. The traded price of a bond vary due to demand-supply dynamics and macro factors such as interest rates in the economy. Accrued interest is reflected every day in the price of the bond until the interest payment date. Once the interest is paid, the price of the bond adjusts (reduces) to the extent of the interest payment.

For instance, take a bond with a face value of ₹1,000 and a coupon rate of 10 per cent per annum. Assuming that other factors remain unchanged, the traded price of the bond at the end of the six months from the allotment date would be more or less equal to ₹1,050 (the interest of ₹50 accrued over the six months is added to the price). The bond price will be around ₹1,100 when it nears the interest payment date, which is one year from the allotment date.

You may notice that the market price of some bonds are traded higher or lower than the price with accrued interest. This is mainly due to the demand-supply dynamics and macro factors. For instance, the date of allotment of the NHAI N1 (INE906B07CA1) series with a coupon rate of 8.2 per cent was January 25, 2012. At the end of the six months, the traded price of the bond on the NSE was ₹ 1,079 (on July 25, 2012). The price quoted was ₹38 more than the face value plus accrued interest — ₹ 1,041. The premium may have been due to strong demand for the bond and/or lower interest rate in the market that pushed up the price of the bond. Bond yields and their prices are inversely related.

So, while investing in tax-free bonds through the secondary market, investors should look at not just the coupon rate and the market price of the bond, but also the YTM (yield-to-maturity), credit rating of the bond and its liquidity. 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 essentially shows the effective return that an investor can get on the purchase of the bond at the current market price.

Those who like to play it safe should pay attention to the bond’s credit rating, for higher the rating, lower the default risk. Bonds rated ‘AAA’ by credit rating agencies have the highest safety cover.

Also, many listed tax-free bonds do not have adequate liquidity in the secondary market. But there are quite a few that trade regularly with good volumes. Your broker should be able to help you with the list of bonds that have good liquidity.

Ex-date matters

Investors should also be aware of the interest payment record date and the ex-date while buying through the secondary markets. Normally, the record date is fixed 15 days prior to the interest payment date. The ex-date is fixed one day prior to the record date.

For instance, the latest interest payment date of IRFC NO series (ISIN: INE053F07900) was October 15, 2018. The record date was fixed as October 1, 2018, and the ex-date was fixed as September 28, 2018 (the previous working day).

The price of the bond drops on the ex-date to the extent of the coupon payment. An investor will be eligible for interest payment if his/her name appears in the company’s books as a bondholder as on the record date.

So, in the above example, only if the investor’s name appeared in the record books on October 1, 2018, would he/she have been eligible for the interest payment on October 15, 2018.

For practical purposes, given that the usual settlement period is two days from the date of transaction (T+2), an investor seeking interest on October 15, 2018, would have to buy the bond at least a day prior to the ex-date (before September 28) to have his/her name on the company’s books on the record date (October 1, 2018).

Reduction in coupon rate

Investors should be aware that investments exceeding ₹10 lakh face value in certain tax-free bonds will result in reduction in the annual coupon rate by 25-30 bps.

That’s because the benefit of higher interest rates in these tax-free bonds is offered only to retail investors — those who invest up to ₹10 lakh. In every tranche issued after FY14, issuers have offered 25-30 bps higher coupon rates to retail investors. If the investment exceeded ₹10 lakh face value, the interest rates were lower.

For instance, in November 2013, PFC issued tax-free bonds with six series. The issuer set a coupon rate of 8.43 per cent for retail investors in the bonds maturing in 10 years, and 8.18 per cent for others.

Similarly, the issuer fixed different coupon rates for retail investors and others in the 15- and 20-year bonds, too. The limit of ₹10 lakh is calculated based on investments across all series in a tranche. This limit also applies in case of purchase of tax-free bonds in the secondary market. The investment value is calculated based on the PAN number of the investor.

So, in the above example, on the record date, if the face value of the PFC tax-free bonds held by the investor exceeds ₹10 lakh, he/she will get an interest rate of 8.18 per cent.

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