Know why government bonds are safer than fixed deposits

Know why government bonds are safer than fixed deposits

Did you know there is an expenditure category that is safer than fixed deposits and earns more when the discount rate goes down? It’s not common for retail investors to buy into government relationships even when they are more secure than fixed deposits.

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

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

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

How to Invest:

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

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

The last and possibly least used alternative 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 ere it matures.

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

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

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

Finally, the expense ratio is very powerful as it needs to be as low as possible. Also, see out for non-government exposure as a way to enhance the returns as then it's surely not a government bond exposure.

Interest Rate Risk:

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

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

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

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

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

If you had a 20-year fixed deposit that paid a 14 percent discount to you now, you would feel pretty good, isn’t it? While that isn’t feasible 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 prepared to pay to borrow from its investors for 10 years using 10-year constant maturity gilt funds.

This is actually cool outside India - for example in Germany, you pay the government interest to keep your business!

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

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

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

How much to designate?

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

Do consult your advisor to determine the one that has the right exposure and the least cost. Also, make positive you consult a fee-only advisor that offers direct mutual funds only.

This is very important as the new trailing fee paid on the regular mutual fund can be 20 percent of the returns. This is a significant point which you must consider.

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

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

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

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