Bond market expects govt to allow huge tax-free bond issuances

It expects the Centre to allow public sector undertakings to raise huge amount of tax-free bonds

With bond yields falling to multi-year lows, a section of the bond market says it could be time the government enables in the budget state-owned infrastructure and infra finance companies to raise enormous amounts of tax-free bonds.
 

The government doesn’t raise tax-free bonds directly. It instead allows state-owned institutions to raise these bonds. The bonds raised by these companies are over and above the government’s borrowings. The government is committed to borrow within a particular limit. For 2016-17, the borrowing was limited to 3.5 per cent of the gross domestic product, which was later reduced by Rs 18,000 crore in the first week of January this year.

“The government forgoes only a small amount on taxes on tax-free bonds, but it largely helps the infrastructure sector. Given the government has good tax buoyancy, what with direct and indirect taxes expected to be good after demonetisation, it may allow a fair amount of tax-free bonds this time around,” said Joydeep Sen, an independent financial advisor.

For any investment cycle to pick up, it is the government and its companies that start investing first. Private sector investment activity has slowed down in the country, as capacity remains unutilised. Once the government starts spending and creating demand, private parties chip in with their own long-term investment cycles. This perhaps could be a perfect time for the government to pick up the tab.

“If government companies are able to borrow at rock-bottom coupons, they can also deploy the money at a cheap rate. Now that the cost of borrowing is so low, it won’t be surprising if the government pushes the public sector companies to start lending for investments, or invest in long-term infra projects,” said Devendra Dash, senior bond dealer at DCB Bank.

The yield on the 10-year bond closed at 6.39 per cent on Tuesday. The yields have held steady below seven per cent since September 2016, around the levels last seen in 2009.

Some, though, disagree that tax-free bonds would spur investment.

“There is an expectation that tax rates itself would come down. If that is the case, the government will have to withdraw tax savings instruments allowed over and above the maximum investment limit. This will reduce the appetite for tax-free bonds,” said the head of treasury at a foreign bank.

However, tax-free bonds will have other advantages for savers. If tax-free bonds are issued in large numbers, banks will not be in a position to bring down their deposit rates below the coupons offered by the bonds. This will, however, constrain their abilities to lower lending rates too.

“High issuances of tax-free bonds at attractive rates will add stickiness in bank deposit rates; as a consequence, rate transmission will get affected. On the contrary, high-rated public sector undertakings are anyway borrowing at attractive rates in an environment of tepid credit demand and high liquidity in the banking sector,” said Soumyajit Niyogi, associate director, Credit & Market Research Group at India Ratings.