Interest rates might fall on tax-free bonds

If there's a rate cut, the tax-free bonds which will hit the market after RBI's policy review might offer lower coupon rates to investors

In a scenario when interest rates are expected to fall further, the coupon rates on tax-free bonds offered by companies this year might be lower than what was offered by state-run NTPC, which got oversubscribed on the first day itself.

The Street expects a rate cut by the Reserve Bank of India (RBI) next week, due to comfort on the inflation front. As a result, the tax-free bonds which will hit the market after RBI's policy review might offer lower coupon rates to investors.

State-run Power Finance Corporation (PFC) is to have a public issue of such bonds on October 5. It plans to raise up to Rs 700 crore, with coupon rates slightly lower in certain maturity buckets.
 

“If RBI cuts the repo rate and government bond yields fall from current levels, coupon rates might go down further. This is because the pricing mechanism for tax-free bonds is such that the related maturity of government securities is considered and the coupon rate is set at the yield of the government security minus 80 basis points (bps). The annual yield is taken into account and the two-week opening and closing yield average,” said Ajay Manglunia, senior vice-president (fixed income), Edelweiss Securities.

In the PFC issue, the interest rates for retail investors will be 7.36 per cent for 10 years, 7.52 per cent for 15 years and 7.60 per cent for 20 years. For NTPC, it was 7.36 per cent for 10 years, 7.53 per cent for 15 years and 7.62 per cent for 20 years.

The Rs 700-crore tax-free issue of NTPC was subscribed 11 times as investors rushed to capture the attractive yield on offer. The issue, the first since FY15, saw demand of Rs 4,400 crore across four investor categories.

RBI will review the monetary policy on Tuesday and it is expected that the repo rate will be cut by a further 25 bps. But, since the bond market is already factoring this in, there might not be a significant rally.

“If this rate cut happens, further cuts might not happen at least till February. I do not see a major rally in the government securities market at this point. This means the coupon rates on tax-free bonds might not be sharply lower for the coming issues,” said K P Jeewan, head of fixed income, Karvy Stock Broking.