Last Updated on April 6, 2016 at 1:27 pm
Tax-free bonds are purchased in the secondary market via a Demat account when either new ones are not available or not attractive. How does one decide between buying existing tax-free bonds and new ones? Should we just look at the coupon rate and choose the one which is higher?
It depends on the purpose of the purchase. If someone is buying these bonds,
1. for income after retirement, then higher coupon rate may be the only thing that matters. There is no point comparing old bonds with new ones. If a higher payout is necessary then a premium may have to be paid to buy old bonds in the secondary market. Whether they will be available for sale or not is another matter!
What is probably more important is the question, “should you (a retiree) buy these bonds for just for tax-free payouts?” If the corpus is large enough, then purchasing these bonds may not be an efficient way to utilise funds. If the corpus is small, then buying these bonds (instead of an annuity) to receive an annual payout may not be convenient, besides the reinvestment risk (returns may be lower when bonds mature)
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2. before retirement (I can never understand why anyone would so!), the coupon rate does not matter. The yield to maturity does, but this has its own limitation if the intention is to reinvest payouts elsewhere.
3. only because of the words ‘tax-free’, no comment.
If I need to decide between buying old tax free bonds and new tax-free bonds which are either available or should be announced soon, then the yield to maturity (YTM) could help.
Yield to maturity is the internal rate of return (IRR) of the bond purchase, assuming all payouts are reinvested at the same IRR. This is practically not possible in real life!
There are many YTM calculators available online and Excel has a function for it. The one from Investopedia is used for the following illustrations.
Reference: Modern Portfolio Theory and Investment (8th edition) Analysis by Elton, Gruber, Brown and Goetzmann.
Example 1
Consider bond New
Face Value : 1000 (amount you will get on maturity)
Market Value : 1000 (new bond before it is listed)
Coupon rate: 7% (interest rate)
Tenure: 15 years
YTM = 7% = coupon rate since market value is the same as face value.
Consider bond Old
Face Value : 1000 (amount you will get on maturity)
Market Value : 1100 (coupon rate higher than new bonds)
Coupon rate: 8% (interest rate)
Tenure: 15 years
YTM = 6.91%
If I buy the old bond thinking that the coupon rate is higher, then the IRR of the investment, assuming payouts are reinvested is 6.91%. This is lower than the required yield of 7% which I can get by simply buying new bonds with lower coupon rate!
YTM for the old bond is 7% if the market value is 1091. A price higher than this will result in a yield lower than the required yield.
Example 2
Old-1 vs Old-2 (both with face value of 1000 and tenure of 15 years)
Bond old-1
Market Value :1200; Coupon rate: 9%;
YTM: 6.83%
Bond old-2
Market Value : 900; Coupon rate: 6%
YTM: 7.11%
Old1 has a coupon rate of 9% and therefore, trades at a premium. If I buy old1 just by looking at a higher coupon rate, I will end up with a lower IRR compared to purchasing Old2. The premium paid ensures the IRR is lower. This is why YTM is a powerful tool. It accounts for the cost of purchase.
However, it assumes reinvestment at the same IRR. If the reinvestment is made elsewhere then the bond with higher coupon rate could be the more attractive investment. For this to happen the reinvestment rate should be attractive (how high it should be, depends on values for both the bonds).
Which then begs the question, if the reinvestment rate is higher, why I can’t simply invest in that instead buying bonds?!!
You can use this tool to consider such options: Tax Free Bonds – Interest payout reinvestment calculator
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