Less warmth for tax-free bonds in FY16

Tax-free bonds, seen hitting the Street in financial year 2015-16, might not be able to get the same attention as when interest rates were higher. The coupon rates on these bonds are expected to be much lower than what was offered earlier.

Last month, the Union Budget had announced tax-free bonds for infrastructure projects. These are popular with wealthy individuals. If the holding period is more than a year, investors have to pay long-term capital gains tax at 20 per cent with indexation or 10 per cent without indexation.

"Since the interest rate cycle is heading down, the coupon rate on these bonds might not be so high. These could still get subscribed but the enthusiasm of investors might not be as good as in past years. Investors might continue to have higher interest in equity investments," said Arvind Konar, head of fixed income, Almondz Global Securities.

The bonds offer a high degree of safety, being issued by top-rated public sector companies. In the past, issuers such as Rural Electrification Corporation, Power Finance Corporation and National Highways Authority of India have hit the market with such bonds. Since the interest rates were higher at the time, these had got subscribed quickly.

"There is still clarification needed on when the tax-free issuances will come and how they would be priced. If you look at the pricing last fiscal, it was related maturity of government security yields minus 85 basis points (bps). That was the maximum coupon issuers could offer in the related maturity. This time, if the same pricing criteria is retained, the coupon rate on tax-free bonds will be around seven per cent, not as attractive as last time. Normally, investors are interested in tax-free bonds when the coupon rate is around eight per cent," said Ajay Manglunia, senior vice-president (fixed income), Edelweiss Securities.

The rate cut cycle by the Reserve Bank of India (RBI) began in January 2015 and so far the repo rate, the rate at which banks borrow from the central bank, has been cut by 50 bps in two tranches. Economists believe more rate cuts are in store in 2015, due to easing inflation.

With each rate cut, government bond yields are seen falling further, thus making returns on tax-free bonds less attractive.