Article published in Financial Express on 20 February 2017. Please click here for the link
Fixed income investments happen mostly through the mutual fund route, and rightly so, because of the advantages of accessibility and liquidity.
Fixed income investments happen mostly through the mutual fund route, and rightly so, because of the advantages of accessibility and liquidity. However, investors need to be aware of the avenue of direct exposure in bonds, for the sake of wider choice.
The biggest drawback of the direct bond route is lack of liquidity in the secondary market. This problem is, however, not there in one segment of the bond market: Tax-free PSU bonds. These bonds are rated top notch, i.e., AAA, and have implicit government support.
The interest payments on these bonds are free of tax, but there would be capital gains tax if you sell before maturity at a profit. The method for dealing in these bonds is similar to that of dealing in equity shares: You have to have the basic set-up with your stock broker. These bonds are listed in the capital market segment of exchanges, and hence can be dealt with in a manner similar to that of equity stocks.
Returns on these bonds are attractive, even at current levels after a rally and yields having come down from higher levels earlier. In market parlance, the yield is referred to as YTM, which stands for yield to maturity. In simple terms, the yield is the return you would get, if you hold the bond till maturity, expressed as compound annualised interest rate. The YTM on tax-free PSU bonds currently is around 6.1%.
The proper perspective to look at the yield on tax-free bonds is the ‘pre-tax equivalent’ and compare it with a taxable instrument, though technically it is tax-free. Taking the tax-free bond yield at say 6.1% and the tax rate at 30.9%, the pre-tax equivalent comes to 6.1% / (1-30.9%) = 8.83%. The yields available in the market for taxable AAA rated PSU bonds is much lower than 8.83%, hence it makes sense to buy these bonds.
Taxable PSU bonds
The other option is taxable PSU bonds / private sector bonds / bonds rated AAA or lower. Primary issuances of bonds happen from time to time as issuers access the market for raising resources, and you can purchase these for relatively small amounts as well.
It is advisable to go with higher rated bonds, AAA or at least AA, to reduce the credit risk in your portfolio. The issue of liquidity becomes relevant again: If you want to sell in the secondary market before maturity, while it is possible to sell, liquidity in instruments rated less than AAA is on the lower side. Best scenario is if you can hold the bond till maturity.
In the secondary market, the ticket size for negotiated deals is on the higher side as the market is wholesale in nature. It is possible to trade relatively small quantums as well, for instance, when a desperate seller is on the exchange, offering a high YTM to encash his holding. However, to take advantage of such offerings, you need to actively track the website of the exchange and need guidance from your debt broker.
You may purchase tax-free AAA rated PSU bonds from the secondary market, as these issuers are not coming with primary issuances as of now, and subscribe to primary issuances of AAA / AA rated issuers, preferably for a tenure matching your cash flow requirements.
The writer is an independent financial adviser and has authored books on fixed income