An investor must mull finer points before choosing government bonds over bank FDs
The RBI recently released the features of Retail Direct Gilt Account as part of its (and the government’s) initiative to encourage retail participation in government bonds.
The question is: should you invest in government bonds? In this article, we discuss the benefits and the issues associated with such investments. For the purpose of our discussion, we will assume that you are investing to achieve a life goal. We also assume that, at present, your preferred choice for bond investment is bank deposits.
You are exposed to interest-rate risk when you invest in bond mutual funds or any bond investment that generates capital appreciation. The risk is that bond prices typically decline when interest rate rises (or in anticipation of rates going up). You are not exposed to this risk if you invest in bank deposits because you earn only interest income.
Now, direct investment in government bonds also protects you from interest rate risk. How? True, government bonds trade in the market and offer opportunities for capital appreciation. But you can choose to earn only interest income by keeping these bonds till maturity and receive the par value from the government. It is possible that you may have to pay a premium to buy these bonds. The point, however, is that you need not bother about prices going down during the life of the bonds. And, of course, government bonds do not have credit risk. So, you can be confident of getting back the par value at maturity.
The upshot? Government bonds offer stable income, just as bank deposits do, and typically without credit risk. But before you do decide to invest, consider an important risk associated with such investments.
Suppose you want to accumulate ₹15 lakh in 10 years. Assuming you have ₹10 lakh today, you must invest in a product earning 4% per annum to accumulate ₹15 lakh in 10 years.
Suppose, you invest in a 10-year government bond offering 4% post-tax interest income. It seems that you are all set to achieve your goal. But unwittingly, you have exposed yourself to reinvestment risk.
To accumulate ₹15 lakh in 10 years, you need to earn 4% on a compounded annual basis. So, the interest income you earn every year must be reinvested at 4% till the tenth year. The issue is that RBI could lower the interest rate in any of the intermediate years. And, that would mean you cannot reinvest at 4%. Referred to as reinvestment risk, this risk, if not managed well, can set you on a path to failure to meet a life goal,
Suffice it to understand that the more frequent the interest payments, the greater the reinvestment risk. Now, government bonds pay every half-year. So, this risk could be greater with government bonds than comparable bonds paying interest rate annually.
You should directly invest in government bonds if you are excited about the newer investment avenue. But, you should consider the following points if your objective is to invest in government bonds for achieving a life goal:
First, both government bonds (if held till maturity) and bank deposits do not carry interest rate risk.
Second, government bonds expose you to reinvestment risk. Bank deposits do not, if you invest in cumulative fixed deposits (for lump sum money) and recurring deposits (for savings from monthly income).
Third, you can invest anytime in deposits and match the maturity of your deposits with the time horizon for your life goal. With government bonds, your primary investment is dependent on when RBI holds auctions, and the bond maturity offered in each auction.
Finally, bank deposits expose you to small credit risk whereas government bonds are typically credit-risk free.
(The author offers training programmes for individuals for managing personal investments)
Source: Read Full Article