Volatile equities driving HNIs to tax-free bonds

Volatile equities driving HNIs to tax-free bonds

In the last one month equity markets have fallen by more than 5%. The Sensex is down over 2,000 points, while Nifty over 600 points. Given this downward trend, it is not surprising that high net-worth investors (HNIs) are getting jittery about their equity investments and are switching to fixed income investments.

There are signs of stress in the debt market, too. But good returns can be made if one selects the right product and stays invested till maturity, experts said. In fact, one benefit for investors looking to enter now is the opportunity to lock in at the current yields.

Why fixed income now?

Investors have become more risk averse in the last six to eight months because of the volatility in the equity market and there is more opportunity in debt right now, said Nitin Rao, CEO, Reliance Wealth Management.

According to Satheesh Krishnamurty, senior VP-affluent business, Axis Bank, investors are increasingly looking to increase their allocation to fixed income instruments, not only due to the volatility in the equity markets, but also due to the higher interest rates prevalent currently. For example, yields for AAA-rated PSU bonds are currently trading in the range of 9% per annum.

“There is a flight to safety. People are looking at tax-free bonds for safety of capital or liquid funds, where they are parking their cash temporarily,” said Prateek Pant, head, product and solutions, Sanctum Wealth Management.

The change in the tax treatment of equities is another reason for investors favouring equities, said Anupam Guha, head – private wealth, ICICI Securities. “Equities had been receiving good flows in the last couple of years as TINA (there is no alternative) factor, due to low yielding debt and sluggish real estate market, worked in its favour. But given the volatility in the equities market, coupled with yields on AAA paper moving up and introduction of long-term capital gains tax on equity, debt has clearly re-emerged as an asset class from the risk-return perspective,” he said.

Debt is not entirely risk-free

“The fixed income portion of an investor’s portfolio is supposed to be super safe, with no credit risk. Risks like a haircut on the rates or not getting the yields as expected at the time of maturity are issues that investors are normally not prepared for in their fixed income investments. So when this happens, it is a larger blow because investors typically have a larger portion of their money allocated to fixed income, because it is supposed to be safe,” said George Mitra, CEO, Avendus Wealth.

Gaurav Dua, head of research, Sharekhan by BNP Paribas, said, “It is not prudent to take unnecessary risk to earn a few extra basis points of returns. Hence, it is advisable to adopt a conservative approach while investing in debt investments.”

Given this scenario, one should look at instruments that offer risk free returns such as tax-free bonds, fixed maturity plans or short-term bond funds, and avoid long duration bonds at this time, said Rao.

“There is a strong secondary market for tax-free bonds. But getting lot sizes could be a problem,” he said.

Tax-free bonds

Tax-free bonds offer sovereign risk. While there is no super-normal return, there are no surprises in case of a Black Swan event. However, availability is an issue, especially if one wants huge lot sizes. One way is to buy wait and accumulate in smaller lots, said Mitra.

In case of tax-free bonds, the liquidity is low and hence sufficient quantum is not available. The existing coupon rates are about 6.4-6.5%, which is closer to 10% on a pre-tax basis. The strategy should be to hold till maturity.

“It is a very good return in today’s environment, if you are able to get decent quantities,” Pant said.

Tax-free bonds provide an annual interest payout which is not taxable. These papers have maturities that range seven to 10 years or more. “If an investor wants to lock in the returns for such time horizons, then tax-free bonds can be considered. However, it is important to remember that there could be an MTM impact here if there is a need to liquidate these bonds prior to maturity,” said Krishnamurty.

Hence, one should look at these investments from the perspective of locking the yields available currently and holding these papers till maturity.

“Since the issuers are all PSUs, the credit risk in these papers is very low. While tax-free bonds are listed and traded on the stock exchanges, the volumes here are very low. Most transactions are done in the over the counter (OTC) market and the preferred lot size here is Rs 5 crore,” Krishnamurty said.

Other options

According to Guha, tax agnostic investors also prefer non-convertible debentures that offer attractive yields from stable names. “HNI investors have looked to invest in short- to medium-term maturity papers, keeping in mind the duration risk brought in by interest rate hike cycle,” he said.

Similarly, another option is FMPs, which are offering close to 9% yields. In fact, some investors are asking for five-year FMPs to try and lock in at these yields, Pant said.

Investors are also looking at structured options which offer minimum guarantee of about 7% coupon through debt investments and an upside through equity participation.

As an alternative, given that fixed income yields were not very high until recently, there were some other options that investors are looking at. One is credit funds, in the Alternative Investment Funds (AIF) space. These are mostly unrated papers and offer yields in the range of 12-18 % total IRR. They are not from real estate sector, but from acquisition finance, etc. The high yield is commensurate with the high risk the investor is taking.

“The difference here is that fund managers are doing the due diligence separately on the underlying securities of these papers,” Mitra said.

For instance, if there is a non-banking finance company that is lending directly as structured credit, then that NBFC may have some credit rating, but the fund manager will also evaluate the underlying security to whom the NBFC is lending, in order to get an accurate assessment of the risk, he said.

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