In November 2013, we made a case for investing in the 20-year tax free bonds of Housing and Urban Development Corporation (“HUDCO”) which paid a tax free interest of 9.01% to retail investors. Just to recap, our reasons for recommending the same included the following:
- Tax-free rate of 9.01% was much better than the after-tax return of 6.30% from Bank FDs at the time (assuming a 30% tax-bracket);
- These bonds were issued by government controlled corporations thereby reducing credit risk;
- The economic environment at the time indicated that likelihood of interest rates falling sooner or later was high. Accordingly, there was a possibility of earning handsome capital gains through increases in the market value of these bonds.
- Even if interests did not fall, investors (especially those falling in the 30% tax-bracket) would end up getting 9.01% as interest every year which was not a bad proposition at the time.
Given the above, we strongly felt that the risk-reward ratio was in favour of investing in these issues.
Today, a little more than 2 years later, we decided to sell these bonds. A summary of the entire investment operation is provided below. The same represents actual transactions carried out in one of the accounts:
|
Year |
Transaction |
Cash Flow |
| 13-Jan-14 | Purchase 1,000 bonds @ Rs. 1,000 | (10,00,000) |
| 13-Jan-15 | Interest received | 90,100 |
| 13-Jan-16 | Interest received | 90,100 |
| April 2016 | Sold 1,000 bonds @ average price of Rs. 1,232 | 12,32,000 |
| Total Return (assuming interest was reinvested @ 6%) | 42.13% | |
| CAGR | 16.57% | |
As you can see, our return from the operation (for a period of little more than 2 years) turned out to be more than 16.50% annually. Or, more than 2.5 times that of a Bank FD!
Icing on the cake!
Wait, that is not all. Since these bonds were held for more than 1 year, the gains (in market value) will be taxed as long term capital gains enabling us to get the benefit of indexation. Although the Cost Inflation Index for Financial Year 2016-17 is pending to be notified, we believe these gains will be almost tax-free!
Why have we sold these bonds?
You must be wondering why we have sold such lucrative bonds which were giving 9.01% interest when the after-tax interest rates on most FDs have fallen further to 5.25%. Let us elaborate:
Suppose we hold the bonds till maturity, we will get 9.01% for 18 more years and at the time of maturity we will get Rs. 1,000 (per bond) back as principal. The opportunity cost of holding the bond till maturity today is Rs. 1,232 per bond. That is, if we do not sell today, it is akin to buying these bonds at a price of Rs. 1,232 and getting Rs. 1,000 after 18 years plus the 18 years of interest.
The table below summarises the total cash flows starting today till maturity:
|
Year |
Transaction |
Cash Flow |
| Today | Purchase 1,000 bonds @ Rs. 1,232 | (12,32,000) |
| Next 18 Years | Interest received (90,100 X 18) | 16,21,800 |
| At Maturity | Principal redeemed | 10,00,000 |
| Yield-to-Maturity | 6.95% | |
Given this scenario, the return of the bonds if held till maturity from today onwards drops to 6.95% (in technical terms this is called the Yield-to-Maturity of the Bond).
Although a 6.95% annual return is still better than the current after-tax Bank FD return, we believe there are other, more lucrative opportunities to invest our funds. That is, we believe that we can invest our funds at rate higher than 6.95% on a risk-adjusted basis.
Also, the risk-reward doesn’t appear as enticing as it was 2 years ago for the following reasons:
RBI Policy
The RBI Governor, Mr. Raghuram Rajan, has reiterated his stance that he wants Indian investors to earn 1.50% – 2.00% real return (i.e. over and above the rate of inflation) from fixed income instruments.
Given the current inflation rate of around 5%, this means that his policy rates would be somewhere between 6.50% – 7.00%. The current Repo Rate is 6.50% with most Bank FD Rates falling to 7.00% – 7.50%. Therefore, any further rate-cuts can be expected only if long term inflation falls below the current 5% mark, likelihood of which, we think is low. Today, the incremental returns from holding on to the bonds in the hope that interests rates would fall further is not commensurate with the risk of loss if they don’t.
The possibility of increase in interest rates
Although the likelihood of rates being increased is currently low, its possibility cannot be ignored. If the economy so warrants, even a marginal increase in interest rates (say 0.50% – 1.00%), would put Bank FDs at equal footing to the tax-free bonds (considering an investor would also suffer loss in market value due to increase in rates).
In light of the above reasons, we felt that the risk-reward ratio was not in our favour anymore and it was best to sell the bonds and invest in better opportunities.
Conclusion
In 2013, we were recommending investing in these bonds to anyone who cared to listen. However, only a handful of our clients actually invested in these bonds.
Today, looking to the performance in the last 2 years, new issues of tax-free bonds (which are coming at lower rates of interest) have again found favour with investors. These issues are being oversubscribed and we are getting a number of queries from inquisitive investors about these bonds. This sudden surge in curiosity indicates that investors are expecting these bonds to replicate the performance of the recent past.
Given financial history, we feel, investors may be disappointed.