Impact 
Want to know what’s in vogue nowadays? Buying tax-free bonds from the secondary market. This is a new trend emerging among High Net Worth Individuals (HNI) and other savvy investors seeking higher returns from fixed income instruments. What may surprise you is, these bonds usually pay interest lower than what banks offer you for deposits of a similar tenure. Still there’s a huge appetite for these bonds in the market. In this article, PersonalFN will share with you the reasons that make tax-free bonds an investors’ darling, and suggestions if you are unsure about investing in them, especially through secondary markets.
Many of you would be astonished to know that several issues of tax-free bonds were oversubscribed multiple times in the recent past. Interestingly, many of the issuers have paid higher coupons in the past to raise money through tax-free bonds, but with declining interest rates, coupon rates dropped subsequently too. To be precise, eight companies used up the threshold of Rs 43,500 crores in FY 2015-16, without exerting any significant efforts. The maturity of these bonds ranged between 10 and 20 years. Coupon is a rate at which a bond issuer agrees to pay you periodically.
Why tax-free bonds?
As you know, the Government has been focusing on infrastructure development across the country. Many infra projects need huge initial and on-going capital investments, and usually take time to generate cash flows. Therefore, the Government allows infrastructure companies or those financing the infrastructure companies to raise funds directly from the public. However, there’s a problem. Unless the Government provides specific incentives, the bonds may not find many takers as they will directly compete with other fixed income instruments such as Small Savings Schemes of the Government, Bank FDs, and so on. Affordability could become a problem for companies floating these bonds. The pertinent question is, should they hike the interest rates to outbid competitors?
Providing them with a solution, the Government made these bonds tax free. Now, many find these bonds attractive.
Let’s understand why...
Rising inflation makes bank FDs look unattractive to many investors. Imagine a scenario where inflation is increasing at 10% and banks are offering the equal rate of interest on their 3-year deposits. Your real rate of return becomes zero in this case. When inflation falls, interest rates fall too.
However, this is a better scenario; you would generate positive real returns on your bank FDs. Those falling in the highest tax bracket, almost always find bank FDs unattractive. This is because apart from inflation, taxes eat into their returns, pushing their post-inflation and tax earnings into negative territory. The tax-free bonds work well for such investors. Naturally so. They help you save tax outgo by bettering your real rate of returns.
Current Scenario...
The average retail inflation for FY 2015-16 was 4.91% and some tax-free bonds, which recently collected funds, offered the coupon in the range of 7.0% to 7.50%. This means, those investing in tax-free bonds had a chance of generating a higher real rate of returns. The RBI and Government have been working concertedly to keep the retail inflation at around 5% over a long term. Moreover, the newly adopted MCLR regime is expected to assist banks in better monetary transmission. In other words, the new system would make the cost of funds for banks economical, making deposits unattractive, and loans attractive.
Learnings for you...
So to invest in any tax-free bond, take a look at the inflationary trends and the difference between the interest rates on other instruments of comparable maturity that have no favourable tax treatment. Thus, while investing in a tax-free bond that will mature after ten years, you may want to compare it to a bank FD of a similar tenure.
Tips for those buying in the primary issue (directly from the company):
- Make sure you have a long time-line horizon
- Hold bonds till maturity
- Invest in bonds with superior credit rating and strong parental support
- Try investing in those issues that come at a time when interest rates appear to have peaked on a multi-year cycle.
If you found the last point difficult to comprehend, please seek an expert’s advice or read PersonalFN’s analysis of various tax-free bonds from time to time.
Those buying through secondary markets need to be very careful though. It is simply picking up bonds that have already been floated by other bondholders. They are traded just like shares. So if you buy bonds in anticipation of lowered interest rates (and bond prices move up due to their inverse co-relation), if they do not, you could be in a fix. The only benefit of buying bonds in secondary markets is that it gives you a second chance to invest in them, if you had missed the primary issue, and the yields are attractive.
If it sounds Greek, please take a deep breath and Read this:
Suppose you buy a tax-free bond with a face value of Rs 100 and a coupon of 7.5% for Rs 105 in the secondary market, your effective yield becomes 7.14%.
Here’s how. You are paying Rs 105 to receive an interest of Rs 7.5 per bond every year. The next logical question would be why are you paying a premium? Simply because like you, there are many others who believe the interest rates in the economy are set to go down so as the inflation. This would make the coupon of 7.5% and your yield of 7.14% even more attractive tomorrow, should interest rates travel south.
Those raking in capital gains by selling bonds in the secondary market for premium must understand that, if they sell these bonds after having held them for a year, they are required to pay tax only at 10% without indexation. However, selling the bond at a premium is not always a right thing to do considering the long tenure of these bonds. What if interest rates moves down dramatically, and remains low longer than you anticipated? There’s a chance you may regret your decision later.
PersonalFN has a simple time-tested suggestion for you—don’t try to time the market. Follow your financial goals, not markets. Tax-free bonds have a merit for those falling in the highest tax bracket.
Impact
Complying with tedious Know Your Client (KYC) norms that often involve much paperwork puts off many potential investors. This is considered one of the reasons for the current state of mutual fund reach. Since people are now accustomed to buying everything online, it is believed that online platforms allowing investors to invest in mutual funds will enjoy greater acceptance. Keeping this in mind, the Securities and Exchange Board of India (SEBI) had allowed e-KYC for the first time in India. Apart from the reason given above, cost of record keeping, human efforts, practical difficulties among others were the factors that encouraged the e-KYC initiative.
What is e-KYC?
It is entirely a paperless process that can be done in two ways. Using your Aadhaar details as KYC, you can invest in mutual funds without any hassles. You just need to log into the website of a mutual fund you wish to invest in, quote your Aadhaar, obtain a One Time Password (OTP), and you are done. The only condition is you cannot invest more than Rs 50,000 in a year per fund house. The good news is SEBI is considering a possibility of doing away with this condition too.
The other option is, to go for the Aadhar based biometric KYC. In this method, you are required to visit a branch of a fund house, give your thumb impression on a small electronic device that tries matching your thumbprints in Aadhaar records, taking care of In-person Verification (IPV). Once they match your biometrics, the fund house obtains your details from Unique Identification Authority of India (UIDAI). The fund house will also note your PAN details.
On the other hand, Non-Aadhaar linked KYC requires you to submit your address proof, proof for personal identification and will need IPV as well. Some fund houses have started providing a facility of online verification; where you present all your original documents on a webcam to the representative of the fund house, who then verifies them with the copies you submitted online. This is an effortless and time-saving process if you are a tech-savvy person and used to handling webcam applications effortlessly.
PersonalFN believes, using e-routes and going paperless may help mutual funds increase their reach. However, there’s no substitute for investor education and the good performance of mutual funds on offer. PersonalFN strives diligently to educate investors and also provides unbiased mutual fund research services.
Impact
India Inc. has started showing early signs of recovery. Markets have been waiting for this moment for more than a year now. As reported by Business Standard dated May 09, 2016, 350 Indian companies that have declared their Q4 results so far have seen their sales growing at 5.6%--the fastest rate experienced in last six quarters. Their net profits too have grown at a healthy pace of 16.9%. The performance of companies engaged in manufacturing activities has also been encouraging. As against the revenue growth of 3.9% registered in Q3 and 3.8% reported in Q4 of FY 2014-15, they have witnessed 5.8% growth in their earnings for Q4, FY 2015-16. Their net profit has gone up 15.8% during the same period.
How long the revival in corporate earnings last?
For quarter ending March 31, 2016, sample of 350 companies considered
(Source: Business Standard dated May 9, 2016)
A few days ago PersonalFN had written an article— Will May Be a Breakout or Breakdown Month This Year? We had urged readers not to pay attention to fancy adages such as “Sell in May and go away.” This was based on the premise that only fundamentals drive markets in the long run and not sentiments. Today, PersonalFN writes this article to caution those who plan to bet big on markets after reading about Indian corporates reporting encouraging Q4 results. There’s a possibility that good results may blindfold many you.
Detailed analysis suggests that lower commodity prices have helped companies improve their operating profit margins. Business Standard further reports that raw material cost of 196 manufacturing companies went down to 44.6% as a proportion of net sales vis-à-vis 45.5% on Y-o-Y (year on year) basis. However, there’s a rise of 20bps on a Q-o-Q (quarter on quarter) basis. PersonalFN believes one should not overlook these facts. After all, nobody knows when the commodity prices will rebound. It is entirely possible that the commodity prices might have already recovered from the trough. Moreover, companies engaged in the service sector, excluding those in the exports of Information and Technology Solutions had a tough time. Transportation and logistics, hotels, real estate, and telecom among others have collectively reported a fall of 21.8% in Q4 on Y-o-Y basis.
To ready more about this story and Personal FN’s views over it, please click here.
Impact
They say, “There are some things that money can’t buy.” This is true indeed. PersonalFN had covered a story on January 20, 2016 What Money Won’t Buy You? Investors’ Trust For Sure. The story had highlighted the apathy mutual fund houses have towards investor education. Mutual fund houses were underutilizing the funds that had been mandatorily budgeted for investor education programmes and were also directing them towards other purposes.
Taking a serious note of it, the Securities and Exchange Board of India (SEBI) directed mutual funds to transfer 50% of the sum earmarked for being spent on awareness programmes to the Association of Mutual Funds of India (AMFI). In another story How Serious Are Mutual Fund Houses About Investor Education? Dated March 11, 2016, discussed why mutual funds have been failing to spread their reach and gain more popularity.
Here comes May and PersonalFN is forced to write another article on the same subject—investor education.
Here’s why...
As per the SEBI directives, mutual fund houses are supposed to transfer 0.01% of their Assets Under Management (AUM) to Association of Mutual Funds in India (AMFI) from April 01, 2016. Commenting on this AMFI Chief said, “Fund houses have already started contributing 50% of the two basis points corpus meant for the Integrated Action Plan (IAP) to Amfi from 1 April. We are likely to form a committee to decide how to utilise the fund during the board meeting slated for the later month.”
What is shocking and discouraging is this—the AMFI is yet to form a committee deciding how the funds for investor education should be utilised. The AMFI chief expressed the inability of the funds’ association in handling large funds.
To ready more about this story and Personal FN’s views over it, please click here.
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