Portfolio Ideas. Why you should bond with govt bonds

There have been debates in the media in recent times about investing directly in government bonds. This debate is based on the recent RBI directive that allows you to use your existing demat account to buy government bonds. In this article, we discuss why direct investment in government bonds is better than buying gilt funds. We also show you how to decide between investing in bank fixed deposits and government bonds.

We start with the premise that you invest to achieve a life goal. Suppose you need ₹1.5 crore in your investment account to fund your child’s education 15 years hence. The objective is not to earn higher returns but to accumulate ₹1.5 crore. While it will be good to have ₹2 crore at the end of 15 years, higher returns typically come with higher risk. And higher risk could also mean that you may have gathered less than ₹1.5 crore in 15 years! You would rather aim to accumulate ₹1.5 crore than make risky investments to generate higher returns and end up with a shortfall in the education account.

It is in this backdrop that you should understand bond investments. When you buy a bond and hold it till maturity, your cash flows are certain — interest income every year and return of par value at maturity. This certainty in cash flows makes it easy for you to meet your life goals. But if you sell the bond in the market, the price you will receive depends on the interest rate view prevailing at that time. If the bond market participants expect interest rate to move up, your sale proceeds could be lower than your initial investment! You, therefore, run interest rate risk — the risk that bond prices fall when interest rate moves up.

The above argument shows that you should invest in a bond whose maturity matches the time horizon of your life goal. So, if the time horizon of your child’s education portfolio is 15 years, you should buy a 15-year government bond. Otherwise, you will be subject to interest rate risk. It is for the same reason that you should not buy gilt funds to meet your life goals. Your gilt fund investments are redeemed at net asset value, which is based on the daily market price of the bonds. You are, therefore, subject to interest rate risk, which you can avoid by investing directly in a government bond and holding it till maturity.

If the time horizon of your life goal is 10 years or less, you should prefer bank deposits; for the interest rate on deposits is higher than the effective rate you will earn on government bonds. If your life goal has a time horizon longer than 10 years, investing in a bank deposit would require you to renew your deposit after the maximum period of 10 years. What if interest rate declines then? You will have to renew your deposit at a lower rate. You can avoid the risk associated with such renewal if you buy government bonds, as they are available for longer maturities.

That said, investing in government bond also subjects you to similar risk. How? Government bonds pay semi-annual interest. You have to reinvest the interest cash flows each time to accumulate the wealth to meet your life goals. So, you run the risk that interest rate could decline during any of the years when you reinvest the interest receipts. You can side-step this issue by investing in cumulative bank deposits, where banks reinvest the annual interest at a fixed rate and pay the entire amount on maturity. So, even for life goals longer than 10 years, you could still choose bank deposits when the difference in interest rate between bank deposits and government bond is small.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in