Are tax free bonds going out of favor?

Fri, 30 Mar Pre-Open

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In the last few months, tax free bonds issued by National Highway Authority of India (NHAI), Power Finance Corporation of India (PFC), HUDCO and Indian Railway Finance Corporation (IRFC) have flooded the market. A tax free bond is an important instrument issued by the government to develop country's infrastructure. Stock exchanges list these bonds, thus liquidity is high. They are rated as AAA by rating agencies. Investors can trade the bonds. The interest earned on the bonds is exempt from tax. But capital gains tax has to be paid on it if one sells early. There is widespread expectation that the interest rate cycle in the economy has peaked and rates will come down in the near term, hence these bonds will come at a premium (listed price will move higher) as they offer better rates. Thus, they became popular instrument for investors to earn higher returns.

The government in the annual budget has doubled the amount to be raised through tax-free bonds to Rs Rs 600 bn for 2012-13 to meet infrastructure funding requirements. But tax free bonds are starting to lose their sheen and becoming less attractive.

There are several reasons for it. First: there seems to be less investor appetite to absorb these issues. This is after the poor listings of HUDCO and IRFC, which seems to have dampened investor demand. Second; The Reserve Bank of India (RBI) has increased the bank rate to 9.5%. So companies cannot invest in instruments with coupon rates less than the bank rate. So, if the coupon offered on these tax-free bonds remains in the range of 8.3-8.5%, companies cannot invest in these bonds.

Regulatory hurdles have made these issues unattractive for insurance firms and mutual funds as they are now taxed on the interest income or coupon of the debt they buy. Thus, the market for tax-free bonds will now be limited to the super rich and retail investor. Third; Issuing companies like NHAI, IRFC have been allowed by the government to raise Rs 100 bn, but they still have to wait for government notification before they can offer tax-free bonds and this usually takes time. Last year this delay was as long as six months.

Thus, unless some of the regulatory and bureaucratic problems area addressed, tax free bonds may become unattractive. This could lead to funding shortfall for major infrastructure projects and ultimately lead to slowdown in growth of the economy.