A new investment opportunity has opened up for Indian investors, with RBI’s new Retail Direct and other platforms (such as NSE’s goBid and Zerodha Coin) allowing retail investors to directly buy government securities from RBI’s primary auctions.
Our previous article on buying g-secs on the RBI Retail Direct platform outlined how you can go about investing on these platforms. As explained in that article, as a retail investor you can now invest sums ranging from Rs 10,000 to Rs 2 crore in dated central government securities, 91-day, 182-day and 365-day treasury bills, State Development Loans and Sovereign Gold Bonds, whenever RBI conducts auctions of these instruments.
But many advisors and media outlets have been quick to dismiss g-secs as an investment for ordinary folk, arguing that g-sec investing is complicated and that mutual funds offer a much better alternative, given their friendlier taxation.
We at PrimeInvestor don’t agree. When evaluating the usefulness of any investment, one needs to consider multiple factors – safety, variety, costs, liquidity – and not just taxation.
Here we compare the direct g-sec option to the mutual fund route to tell you how and when direct g-secs can add value to your portfolio.
Gilt vs debt mutual funds: the pluses
On doing an honest comparison of the two routes, here are the aspects on which we found direct g-sec investments scoring over MFs.
#1 Higher capital safety
One of the key reasons why investors look at g-secs relative to other fixed income instruments is their sovereign backing which leads to capital safety. Direct investments in g-secs offer better protection against losses than gilts owned through the mutual fund route.
Here’s why we say this. There are gilt instruments across maturities that a retail investor can invest in, on the RBI Direct platform. In mutual funds, retail investors taking the mutual fund route to gilts can buy dedicated g-sec funds, but these funds are typically for longer-term timeframes and are not short-term.
Today, there are 28 mutual fund schemes investing only in gilts across the active and passive modes. But these gilt MFs generally take active calls on portfolio duration, that expose you to interest rate risk. We found that 26 of 28 gilt funds today maintain long average maturities ranging from 4 years to 20 years, while only two funds (Franklin India Government Securities and LIC Government Securities) have less than 2-year average maturity. Should interest rates rise, most gilt funds will thus expose you to capital losses or low returns due to falling g-sec prices.
For short-term periods, there are no dedicated short-term gilt funds. Retail investors can only use debt categories such as liquid, ultra-short, short and low duration funds. These funds primarily use instruments such as corporate commercial paper, bank certificate of deposits, other corporate or bank debt instruments in their portfolios – they devote only some portion of their portfolios to g-secs or T-bills, if at all.
In these debt categories, you may avoid rate risk but end up taking some credit risk or liquidity risk or even duration risk in categories such as banking & PSU debt, all of which can reduce capital safety. Episodes with liquid and short-term funds in the past and the recent Franklin Templeton saga tell us of the risk potential in these funds if they move down the rating scale or take duration risks. It is true that for the most part, these funds stick to top-rated corporate or bank debt and returns can be higher. But even so, their capital safety is still a few notches below that of treasury bills.
When you buy treasury bills or short-dated g-secs through the direct route, you need have no worries about either rate risk or credit risk. You can simply hold the security till maturity to earn sovereign-guaranteed returns with safe return of your capital.
#2 No mark-to-market
One of the key disclaimers you come across when buying into any mutual fund is that returns are subject to market risk. This applies to funds holding gilts or T-bills too.
Open-end debt funds allow free entry and exit to investors at the prevailing NAV. This is certainly advantageous for an investor who needs liquidity at short notice. But this very same feature also renders debt fund returns unpredictable for investors who buy them. Every debt fund is required to mark its bond holdings to market every-day. Even relatively stable categories like liquid funds have been brought under a stringent mark-to-market regime in recent times. This means that, irrespective of whether the fund plans to hold a g-sec or T-bill (or any other debt instrument) to maturity, its NAV will be volatile based on daily movements in g-sec or other bond prices and yields.
The MTM rule leads to uncertainty about the exact return that a debt fund can deliver to its investors, even if their investment horizon broadly matches the fund’s maturity. Investors tend to use a debt fund’s latest Yield to Maturity (YTM) as a rough guide to its likely returns. But the expenses charged by the fund, big inflows or outflows or a change in the portfolio composition can all lead to a deviation in a debt fund’s actual investor returns, relative to its YTM.
When you directly buy g-secs or T-bills and hold to maturity, you get complete predictability of returns and can completely side-step this MTM risk. On December 8, the RBI auctioned off 91-day, 182-day and 364-day T-bills. The auctions concluded at cutoff yields of 3.48%, 3.81% and 4.12% respectively. Retail investors who were allotted these T-bills at Rs 99.13, Rs 98.13 and Rs 96.04 respectively, can expect these bonds to be redeemed exactly at Rs 100 on maturity date, fixing their effective returns.
#3 No flow worries
With open-end funds, even if you personally follow a disciplined approach and diligently stay the course through ups and downs in the NAV, other investors in the fund can screw up your return experience. MFs pool all kinds of investors into a single portfolio and the presence of other large, jumpy, short-term focused or risk-averse investors in your fund can impact your returns from it.
For instance, in a fund holding long-dated g-secs, inexperienced investors may rush out when past returns are negative and rush in when past returns are in double digits. This will mean outflows when the rate cycle is peaking and inflows when the rate cycle is bottoming. A sensible investor should be doing exactly the opposite! Such knee-jerk reactions can force the fund manager to sell securities when he should be buying and acquiring securities when he should be staying away. Mistimed inflows and outflows can thus impact returns for staying investors.
When you buy g-secs through the direct route, your investment actions are under your own control. Your decision to hold to maturity need not be affected by market movements or the ill-considered actions of other investors in the g-sec market.
#4 More maturity options
When choosing debt mutual funds, AMCs often ask you to match your investment horizon to the fund’s maturity profile. SEBI’s categorisation also tells you what debt category you must choose for different investing horizons – liquid funds for horizons of up to 91 days, ultra-short for 3-6 months, low duration funds for 6-12 months, money market funds for up to 1year, short duration funds for 1-3 years and so on. You can also check out a fund’s average maturity or Macaulay Duration to match horizons.
But given that debt fund managers like to mix and match securities in their portfolios to maximise yields, the Average Maturity or Macaulay Duration of a fund need not accurately reflect the maturities of individual securities in the portfolio.
When you match your investment horizon with the fund’s average maturity or Macaulay Duration, it is therefore not a given that you completely avoid rate risks. Yes, target maturity funds solve this problem by fixing their maturity date. But these funds are available only in very limited tenures such as 5 years, 7 years, 10 years and so on right now. For you to make the most of such funds, your investment horizon must fit into these preset maturities.
In contrast, the g-sec market offers you a far wider choice on maturities. Investing directly in T-bills or g-secs not only allows you to fix your maturity date with certainty but also allows you to choose from a range of tenures. Apart from 91-day, 182-day and 364-day T-bills, RBI auctions 1-year, 3-year, 5-year, 7-year, 10-year, 20-year, 30-year and even 40-year g-secs.
Not all of these may be available at all times. But then, there are no other MF or FD options in the market that can help you invest in debt instruments with 20, 30 or 40-year tenures, that too with assured rates. RBI sometimes decides to re-issue older g-secs with in-between tenures too. In such auctions you can get your hands on g-secs with odd residual maturity such as 2 years, 4 years or 6 years. The availability of RBI’s auction calendar in advance helps you participate in auctions with specific tenures to match your horizon.
#5 Cost advantage
When you own g-secs via mutual funds, even through direct plans, the returns you earn are net of the funds’ Total Expense Ratio. Gilt ETFs can be subject to both TER and transaction costs charged by the exchanges. The costs associated with participating in direct retail g-sec platforms are much lower. Brokers such as Zerodha Coin charge an ultra-low 0.06% as brokerage when you invest in g-secs. RBI’s Retail Direct Platform comes completely free and doesn’t charge you any account opening, maintenance or transaction fee for buying g-secs in primary auctions.
Gilt vs debt mutual funds: the minuses
#1 Unfriendly taxation
One of the biggest disadvantages of buying g-secs directly rather than taking the MF route is that you’d lose out on the friendly taxation of debt mutual funds. Current tax rules allow you to convert the interest income that you earn on your debt fund portfolio into capital gains to benefit from lower rates of tax.
When you invest in a growth option of a debt fund and hold on for 3 years, all your NAV returns from the fund (which will include interest receipts and capital gains) get taxed at 20% after applying indexation benefits. This makes only your real returns from debt funds subject to tax and really lowers your tax outgo, bolstering post tax returns. When you directly buy g-secs though, your interest income is added to your income in the very same year and taxed at your slab rate. For tenures beyond 3 years, you don’t get indexation benefits which can significantly boost your post-tax returns in debt MFs.
However, the tax argument does not apply when you plan to invest in g-secs for less than 3 years or for the extremely long-term like 20, 30 or 40 years (because comparable MF options are not available).
#2 No compounding benefits
When you invest in the growth option of debt funds, the interest accruals on the portfolio automatically get reinvested at prevailing rates, giving you compounding benefits in the long run. With g-secs which pay out half yearly interest, there is no cumulative option or compounding benefit. Unless you reinvest the interest, this means missing out on substantial compounding benefits in the long run.
#3 Uncertain liquidity
As we explained in our earlier article on the RBI Retail Direct platform, India’s secondary market for bonds lacks depth even if you’re only dabbling in g-secs. Given that retail investors are restricted to the Odd Lots segment and that very few g-secs (like the most recent 10 year and 5 year) get traded each day, any exit from the g-secs you buy in primary options may not be practical. MFs in contrast offer you the facility of anytime exit at NAV.
#4 No help with selection
While most Indian investors are quite familiar with equities, they’re not well acquainted with how bond markets work. The inverse relationship between interest rates and bond prices and the heavy dose of jargon about cutoff yields, yield curves, term premiums, spreads et al may make g-sec selection seem very complicated to first-time investors.
But then, any new asset class is puzzling at first and learning about the g-sec market is an investment that is well worth it. After all, how difficult can it be to choose sovereign backed bonds that pay out an assured return? There’s not much room to go wrong with g-secs if you hold till maturity!
Directly investing in g-secs, therefore, are especially useful if you prioritize capital safety and certainty or predictability of returns over higher returns. Gilt mutual funds may well deliver higher returns than the yield of a single g-sec – but this comes from active management of duration, which leads to volatility and is rather hard to take for many investors. You don’t need to dedicate your entire portfolio to g-secs, too! You can always include these as part of your debt investments, to balance against the risks you’re taking in your debt funds.
G-secs also come especially in handy for Investors who want to set up monthly income streams, such as retirees, as they offer a great combination of capital safety, long maturities with reasonable coupons.
Of course, as pointed out, the challenge is in selection. But when you have us, there’s a solution! With the g-sec market now more accessible, we’re working on building g-sec recommendations, for regular retail investors and retirees based on opportunities. We’ll let you know!
