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RBI has made it easier for small investors to buy government bonds. Find out if you should buy gilts directly or take the mutual fund route.
The government securities (G-Sec) market is dominated by institutional investors like banks, insurance companies, mutual funds and provident funds. Deals typically run into crores of rupees, leaving very little scope for small investors to participate. This could change next week with the introduction of a system that allows all demat account holders of NSDL and CDSL to buy and sell G-Secs on the RBI-managed Negotiated Dealing System Order Matching (NDS-OM) platform.
All banks and primary dealers (PDs) of G-Secs are already members of the NDS-OM and retail investors can route their buy and sell orders through them. G-Secs are usually held in subsidiary general ledger (SGL) accounts. Once your order is executed through banks or PDs, The Clearing Corporation of India will convert the SGL to demat form and transfer it to individual demat accounts (see box for operational details).
Positive move by RBI
Everyone agrees that this is a good move because small investors don’t have access to long-term fixed-income instruments. Bank fixed deposits have a maximum tenure of 10 years. But one can buy G-Secs of up to 30 years. “Allowing inves tors to invest in G-Secs directly is a good initiative because they can lock-in to long-term (10-20-30 year) bonds,“ says C.V. Ganesh, Chief Operating Officer & Head-Digital Channels, HDFC Securities.
The move will especially suit pensioners looking for a safe investment option that can give them assured returns for the long term. Right now, the yield of 2030 year bonds is more than 8% (see table) which is 100-125 basis points higher than the annuity rates offered by most pension providers.
There is no purpose in buying shortterm G-Secs as the yield of bonds of up to five years is lower than what bank FDs are offering. Though many banks offer even higher rates, we have used the SBI rates. Bank FDs score over gilts because they are more liquid. Most banks allow investors to break an FD without a penalty. However, if investors need to withdraw from the G-Secs, they will have to sell them in the market and liquidity can become an issue.“Though G-Secs are more liquid than corporate bonds, it is not clear how liquid the new retail structure will be,“ cautions Anil Rego, CEO, Right Horizons.
Get ready for volatility
However, before you enter this market, make sure you understand it well. The bond market is significantly complicated, especially if you are buying from the secondary market and don’t intend to hold the bonds till maturity. While the coupon rate and yield to maturity (YTM) will be same when you buy in the primary market, it can vary drastically for secondary market purchases. YTM is computed on the assumption that the investor is holding the paper till maturity and the interest received gets re-invested at an interest rate equal to its YTM. And as a thumb rule, go for GSecs that offer the highest YTM. The tax laws complicate the computation further. While the interest received from the bond is fully taxable at the marginal rate, there is also the capital gains to consider.The post-tax yield of two G-Secs with the same YTM may not be same. For instance, if an investor buys a bond priced at `90 (below its face value of `100), he will earn capital gains of `10 if he holds the bond till maturity. On the other hand, another investor buys a GSec for `110 (more than the face value of `100) because the coupon rate is more than YTM. He will book a capital loss of `10.
There are more complications.Indexation is not allowed for instruments that have an interest component. If the holding period exceeds one year, the capital gains are treated as long-term gains and taxed at 10% without indexation. Smart investors can manage their taxation by timing the buy and sell. For example, investors who want to book capital gains can sell the bonds just before the interest is paid out and those who want to book capital losses can sell just after they pocket the interest. Note that booking capital loss may not be of much use here because interest is taxable.
Gilt funds make it simpler
Feeling lost? We don’t blame you because this is a complicated market. The average small investor will find it much simpler to take the mutual fund route and invest in a gilt fund. Mutual funds are also more tax efficient compared to investing in G-Secs directly. This is because the interest received on G-Sec is taxable in the hands of investors. So it may not suit investors in the highest 30% tax bracket. If someone in this bracket buys a G-Sec with a coupon rate of 7.2%, his post-tax yield will be only 4.98%. However, in mutual funds, this taxable interest gets converted into capital gains. This is because the mutual funds are pass-through instruments and therefore, there is no tax-incidence at that time. The capi tal gains are taxed at 20% after indexation if the holding period exceeds three years. If we assume the same 7.2% return from the gilt fund and an indexation of 5% due to inflation, the 20% tax will be levied only on the remaining 2.2% (20% of the 2.2%). So the post tax yield from the gilt fund will be higher at 6.76%.
Another problem is the extreme volatility in the secondary bond market. Since bond prices are inversely correlated to interest rates, prices zoom when interest rates fall. On the other hand, G-Secs quote at a discount when rates are hiked. “G-Secs are good products, but lay investors should not confuse them with assured return products such as bank FDs. There is a possibility of capital loss in GSecs,“ says Dwijendra Srivastava, CIO (debt), Sundaram Mutual Fund. Abhimanyu Sofat, Co-founder, AdviseSure, believes that the volatility may emotionally impact investors even if they are ready to hold till maturity. “If the interest rates start reversing and G-Secs trade at a discount, lay investors may feel cheated,“ he says.
Who should invest
G-Secs can be a good option for senior citizens and retirees looking for long-term assured income.They can buy 20-25 year bonds and be assured of a steady income for the full tenure of the bonds. However, note that this income will be fully taxable. More importantly, it will progressively become insufficient as inflation pushes up their requirements every year. But it will still be a better option than annuities provided by insurers.
If you are investing for the shortto medium-term or don’t have a fixed invest ment horizon, then go through gilt funds. “Direct G-Sec investors have to keep on reinvesting coupons and the mutual funds route relieve investors from that headache“, says Srivastava.“Gilt funds offer better experience because of the fund management expertise it brings in,“ says A. Balasubrahmanian, CEO, Birla Mutual Fund. This expertise comes at a price: fund houses charge 0.5-1% every year for managing your money. “Actively managed gilt funds usually recover the fund management costs and beat their benchmark comfortably,“ says Rego.
Open-ended gilt funds are also more liquid. You can redeem and get your money within a day’s time.In direct G-Sec investments, it can take longer. In the first step, only banks and PDs who have direct access to the NDS-OM will be doing it, so the liquidity may not be high, especially if you want to trade. Stock brokers are staying away for the time being because most of them are not PDs. “As of now, we don’t have access to NDS-OM. So we are evaluating the possible options to offer this service to clients,“ says Ganesh. Since there is not much business expected from here, banks also may not try to popularise this avenue. “G-Secs may not become popular in near future because banks may continue to push the products they are interested in,“ says Rajiv Deep Bajaj, VC and MD, Bajaj Capital.
Is it time invest now?
The bond market has been rallying for almost 6 months now. The 10year benchmark bond yield fell below 7.17% on Friday. The general expectation is that rates will continue to decline in the short term. “Due to several favourable factors, the 10-year yield may break the 7% lev el and may remain below that for some time,“ says Balas ubrahmanian. However, experts say this is not the time to take aggressive bets because we may be close to the lower end of the cycle. “G-Sec yield has not yet bottomed out, but the risk-reward is not favourable anymore,“ says Rego. We studied the average 1-year return from gilt funds at various bands of the bond yield. When the 10-year yield is between 9% and 10%, the average 1-year return was 16%. Investors lost when the yield was between 5% and 6%. As of now, it is placed between 7% and 8% and historically, gilt funds generated only 6% returns in the next one year in such situations.
However, very long-term investors can get in without much worry.“Investors getting in now should get into 10-year plus duration. The interest rate will come down in the long term because we are transforming from a developing economy to a developed economy,“ says Tanwir Alam, CEO of Fincart.