Fixed deposits vs G-Secs

Go for bank deposits if the time horizon for your goal is 10 years or less

With the RBI encouraging retail participation in government bond auctions, several readers of this column wanted to know if investing directly in government bonds is optimal. Therefore, this week, we discuss whether you should buy government bonds (G-Secs) or invest in bank deposits to fulfil the bond allocation in your goal-based portfolios.

Reinvestment risk

You can buy G-Secs through non-competitive bids at primary auctions. You should check if your online broker offers you the facility to bid for bonds. Your choice of investment between government bonds and bank deposits is simple: you should prefer bank deposits if you are pursuing a life goal that has a time horizon of 10 years or less. Why?

One, you can invest in cumulative fixed deposits, whereas government bonds pay half-yearly interest. So, government bonds expose you to reinvestment risk.

Suppose you decide to invest 60 per cent in equity and 40 per cent in bonds to achieve a life goal with a nine-year time horizon. Further suppose you expect to earn 5 per cent post-tax annual returns on bonds and 10.8 per cent post-tax annual returns on equity. Your total expected post-tax returns on the portfolio with a 60:40 allocation is 8.48 per cent. If you want to accumulate ₹50 lakh in nine years, you have to invest 30,800 every month for nine years earning the annual expected return. That means the interest income you receive each year should be reinvested at 5 per cent for the nine-year period.

Cumulative bank deposits compound your interest income at the contracted interest rate. Government bonds do not. So, you have to find avenues to invest your interest income from government bonds. What if interest rate declines? You will have to reinvest at a lower rate then. That is the reinvestment risk.

Two, investing in a government bond depends on the government bond auction calendar. You may want to invest next week for a 10-year goal, but the RBI may not hold a 10-year government bond auction then. Also, the RBI does not hold auctions for all maturities. So, it is unlikely that you will find a seven-year government bond to match your seven-year goal. You can, on the other hand, custom-tailor the maturity of your fixed deposits according to the time horizon for your life goal.

That is not all. The nature of your investment process is likely to determine your choice of investment. If you plan to save every month, you can only choose a bank recurring deposit. This offers two benefits. One, you can set up an auto-debit to your salary account every month. And two, the interest rate on this deposit is compounded periodically, saving your portfolio from reinvestment risk. You do not have this facility with government bonds.

So, when should you invest in government bonds?

Long tenures

Banks typically offer deposits for a maximum period of 10 years. So, what should you do if you want to pursue a life goal that has a time horizon of, say, 15 years? You have to invest in a 10-year deposit and renew thereafter for five years. But what if the interest rate declines at the time you renew your deposit?

Alternatively, you can invest in a public provident fund (PPF). But what if you want to invest, say, ₹2.5 lakh in bonds every year for the next 15 years? You can first exhaust the maximum limit of ₹1.5 lakh in PPF and then consider investing the remaining ₹1 lakh in government bonds.

Of course, this presupposes that the RBI offers a bond for the maturity that matches the time horizon for your life goal. Therefore, you may have to often invest only in bank deposits. True, government bonds offer credit-risk-free interest. But it exposes your portfolio to reinvestment risk and does not help in maturity-matching the investment with the time horizon for your goals.

The writer is founder,

Navera Consulting. Send

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