How to buy tax-free bonds in the secondary market

Published: April 6, 2016 at 1:27 pm

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)


Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

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

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.

  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter with the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

Explore the site! Search among our 2000+ articles for information and insight!

About The Author

Pattabiraman editor freefincalDr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu gets a superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision-making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it and teach him several key ideas of decision-making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & it's content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)