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Why government bonds are safer than fixed deposits?

Did you know there is an investment category that is safer than fixed deposits and earns more when the interest rate goes down?

In our previous article on asset allocation, we talked about being overweight on government bonds. It’s not common for retail investors to buy into government bonds even when they are more secure than fixed deposits.

Did you know that the Indian government guarantees 100 percent of investment in government bonds but up to 5 lakhs only as fixed deposits in banks?

If you find yourself in unfamiliar territory with government bonds, you are not alone. According to the SEBI survey of investors in 2015, 99 percent of the Indian population is aware of fixed deposits but less than 7 percent is aware of debt as a choice of investment.

So, a natural question is that if there is no risk, why isn’t everyone investing in government bonds instead of FDs. The main reason perhaps is that banks take cash, but you can’t buy government bonds with cash.

How to Invest:

There are really three ways to buy government bonds. Easiest is through mutual funds that are categorized as gilt, money market funds, and low duration funds.

The second method could be to purchase from exchanges or participate directly on the NSE bond auction platform available to retail investors.

The last and possibly least used option is to buy it via a broker. We prefer going through the mutual fund route in case you want it opportunistically and need liquidity from it before it matures.

The main advantage of a government bond mutual fund is that you don’t need to analyze it based on credit rating as there is virtually no default risk by the Indian government.

Instead, there is something called duration risk or in simple terms, interest rate risk. This is very important to understand as this can have huge implications on the allocation. Additionally, there is reinvestment risk and concentration.

Interest risk can be mitigated by a professional view on duration risk. Concentration risk can be removed by ensuring the selected fund invests in at least 4-5 bonds.

Finally, the expense ratio is very important as it needs to be as low as possible. Also, watch out for non-government exposure as a way to enhance the returns as then it’s strictly not a government bond exposure.

Interest Rate Risk:

The bulk of the risk is interest rate risk. Simply put, interest rate risk is how much your portfolio will lose if the government is prepared to offer more interest than what they are currently offering.

So essentially if the government is prepared to pay more for a new bond versus what it did for the bond it issued earlier. The old bond becomes less attractive isn’t it? This can be precisely calculated and this is exactly the reason the price of the bond goes down.

So, while you get coupons from the bond, the yield on the overall portfolio can go down when the interest rate increases. The other way round is also true.

If the future interest rate that government needs to pay to borrow is lower than the one you have, the value of the older bonds goes up.

Do you remember a time when you could get 14 percent in fixed deposits? Even very recently 8 percent was quite easy. Now, getting 6.5 percent is normal.

If you had a 20-year fixed deposit that paid 14 percent interest to you now, you would feel pretty good isn’t it? While that isn’t possible anymore, you can lock in a yield for up to 30 years in India.

You can also lock in the interest rate the Indian government is willing to pay to borrow from its investors for 10 years using 10-year constant maturity gilt funds.

This is actually negative outside India – for example in Germany, you pay the government interest to keep your money!

So what are the drivers for the interest rates to go up and down? Where is it decided?

Interest rates are increased to attract more money from people into banks and lowered to discourage people to park money in banks. If there is no one wanting to borrow from a bank, RBI is forced to reduce interest rates to incentivize borrowing.

Without borrowing there is not enough money for growth, and with growth comes inflation. So the role of RBI is to ensure that the inflation target of 4 percent is within the 2 percent range. This inflation targeting has implications on what future bond yields are likely to be.

How much to allocate?

You might consider reducing your fixed deposit exposure. There are lower tax incidence and reduced default risk by switching to gilt mutual funds. There are few AMCs that offer gilt funds.

Do consult your advisor to choose the one that has the right exposure.

I would recommend that you keep Rs 2-5 lakh in FD as emergency money that you can liquidate for a medical emergency and move all the other FDs into government bond mutual funds.

The remaining FDs can essentially be reallocated to gilt mutual funds. Your taxes will be reduced as you don’t need to pay advance tax on FDs as before.

Also, they will be taxed as debt and not marginal income and is especially suitable for investors in the higher tax bracket.


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