Challenges in the present environment
Over the last 5 years, bank interest rates have steadily declined. This is because the RBI embarked on its policy to boost the economic growth of the country. A major PSU bank cut its 1-3 year FD rates to 5.5% last week. Return on FD investments will be unacceptable to many investors since it will struggle to bear the inflation rates. Interest rates are only likely to stall further because economic growth has come to a standstill in the wake of the COVID 19 pandemic.
Over the last year or so, even debt mutual funds which were good alternative fixed-income investment options, have also had their share of challenges related to credit risk. A liquidity crisis in NBFCs has also led to a series of credit rating downgrades, and a default/delay in payment by the issuers. This has in turn impacted the return of several debt funds. Furthermore, the pandemic has led to parts of the corporate bond market turning illiquid, which has again led to unfortunate consequences for investors.
Where to invest your money to preserve long term capital?
Interest rates of bank deposits have declined significantly. In such scenarios, debt mutual funds are good fixed-income investment options to avoid any credit risks.
Negative returns over the last 1 year have largely been due to credit risk, while gilt funds that invest in government securities gave excellent returns.
Debt funds with long-duration profiles will outperform in the current times since interest rates are likely to go down further. The RBI has also reduced the repo rate by 115 basis points, including a 40 bps rate cut. Repo rates are now at a historic low, and the RBI governor has hinted at a further rate cut if eases. Bond yields have come down over the last 2 years, but yields are still high with a lot of scope of decline in the coming years.
Interest rate risk
Government securities or gilts have no credit risk. This is because they have the guarantee of the government. They are also the best-fixed income investment option for those who want to avoid credit risks.
However, gilt funds have interest rate risks associated. The longer the duration of a fixed-income security, the higher the interest rate risk. On average, the maturity period for Gilt funds is 8.4 years. this is why these schemes have considerable interest rate risks. In favorable interest rate environments, the long duration of these schemes leads to higher returns and capital appreciation. However, in an unfavorable interest rate environment, rising yields also hurt the returns of these schemes.
Maturity roll down
Investing in fixed income security and then holding it until maturity will reduce the interest rate risk to practically zero at the time of maturity.
Suppose you have invested in government security which will mature in a decade. After 3 years, the residual maturity of the instrument will remain just 7 years. as the duration of the instrument declines over time, the interest rate risk also reduces. Thus, with maturity roll down, the risk of your investment will also reduce the investment tenure.
In these tough times, capital preservation is of utmost importance for many investors. However, investors also want inflation-beating returns on their investments. Debt funds have now come under a cloud due to credit risks, though they were the usual investment option for investors previously.
What comes across as a viable solution is an investment strategy that preserves your capital by investing in government securities, which have no credit risk. At the same time, it will protect your investment from interest rate risks over a long term investment horizon.
Since interest rates will likely reduce, you can also get the advantage of potential capital appreciation. With investment tenures longer than 3 years, you can also avail of the long term capital gains and tax advantage of debt funds. Speak to your financial advisor about debt schemes that roll down G-Secs, and preserve your long term wealth!