Treasury Bonds: The new investment idea of 2022

FII’s purchased Indian bonds worth $3.4 bn last year as compared to $5 bn inflows in the pre-pandemic year of 2019. (Photo: iStock)
FII’s purchased Indian bonds worth $3.4 bn last year as compared to $5 bn inflows in the pre-pandemic year of 2019. (Photo: iStock)

Summary

  • 2022 could be a good time to lock in an investment in government securities at a higher yield for the long term.

 

Over the last few years, debt investments as a whole have left investors disappointed.

Excess liquidity and RBI’s measures to boost the economy resulted in lower returns from debt funds. To make matters worse, some corporate bond downgrades too impacted debt funds negatively.

Traditionally, conservative investors have parked their short-term money in fixed deposits (FDs). The savvier ones have used liquid and overnight funds.

With the returns from these funds declining below the inflation rate, and the real rate of returns turning negative, even conservative investors have been lured into investing in the equity markets.

And the numbers are there for all to see…

Equity-oriented mutual fund schemes saw a net inflow of  ₹910 bn in 2021, marking a multi-fold jump from  ₹94.1 bn of the net inflow seen in 2020.

On the other hand, debt mutual funds saw net outflows of ₹350 bn in 2021 as investors shied away from the category amid a fall in returns and as investors waited on the side lines, anticipating interest rate hikes by the Reserve Bank of India (RBI).

But although equity markets & equity funds have rewarded most investors over the last two years, making money seems to be a tough task from now on.

So, what should investors do?

Could 2022 be a year of debt once again if yields rise on increasing prospects of a rate hike?

While the Sensex crossing 60,000 dominated the news in 2021, what went unnoticed is that overseas funds, which own the bulk of Indian equity assets, quietly bought more of local debt than stocks last year.

FII’s purchased Indian bonds worth $3.4 bn last year as compared to $5 bn inflows in the pre-pandemic year of 2019.

But in reality, Bonds, on the other hand, received US$4.5 bn through the voluntary retention route (VRR) of the RBI.

By contrast, their net stock purchases amounted to US$3.9 bn for the same period.

VRR investments have to be held for a minimum of 3 years by investors and are counted outside the general debt limit prescribed for FIIs.

The expectation over India's inclusion in the global bond indices may have possibly triggered interest among global investors.

This inclusion is expected to bring in more dollars into bonds raising demand for Indian debt.

Bonds in major economies continue to give negative real returns as bonds trade at dismal lows. This should help Indian bonds as well.

There is also a view that equity markets may have peaked in the short term and the uncertainty over interest rates going forward may push international investors to explore Indian debt securities as they offer relatively higher returns with safety.

Buying Government Bonds Directly from RBI

Following the launch of the 'RBI Retail Direct Scheme', you can now invest directly in government securities (G-secs) by opening an account with the RBI. 

Earlier retail investors were not allowed to invest in G-secs directly.

Government bonds are the safest bonds in India since the government effectively guarantees them.  

Retail investors can invest a minimum of ₹10,000 and in multiples thereof in Central Government Securities (CG), State Government Securities (SG) and Treasury Bills (T-Bills).

You would think that considering these bonds offer the highest safety, they should obviously carry the lowest interest rate as compared to say a bank deposit, right?

But that may not always be the case.

Currently, a fixed deposit placed with say HDFC Bank for a period of 5 years yields 5.6% p.a.

On the other hand, a G-sec maturing in 2027 currently yields 5.87% per annum.

Another reason why one may want to buy a government bond is if an investor is looking at fixing an annuity over a long-term horizon.

Traditional debt instruments do not offer products beyond 10 years. On the other hand, RBI has issued 40-year bonds which offer decent returns.

So, should you invest in Government securities?

As an investor, you need to understand the interest rate cycle and maturity of government securities.

In recent times, due to lower rates, people have been reluctant to invest in papers with longer term maturities as they expect interest rates to go higher.

For example, if you purchase a long-term bond with an interest rate of 6.5% and if the interest rate goes up to say 7.5%, the value of your bond would decline.

However, this is more relevant to short term investors who park their money in gilt funds and trade in the g-sec market.

Such price movements are not relevant if you buy the bond and hold it to maturity.

For a hold to maturity investor, it is like a fixed deposit with no credit risk. The government is expected to pay up as promised once the tenure of the bond is over.

The current yield on the 10-year government bond (G-Sec) is 6.54% In other words, if you hold the bond for 10 years, you will get a return of 6.54% per annum.

For investors looking at a shorter duration, one can invest in Treasury bills.

Treasury Bills are short-term borrowing tools for the government. They are promissory notes with guaranteed repayment at a later date.

They have a maximum tenure of 364 days; issued in three maturities — 91-days, 182-days and 364-days.

Currently, treasury bills offer yields in the range of 3.88% to 4.66% depending on the tenure.

Another interesting option in an expected scenario of rising yields could be investments in RBI Floating Rate Savings Bonds, which re-adjust their yields in line with interest rate movements.

The floating interest rate is linked to the rate on National Savings Certificates (NSCs). It is currently 7.15% and is revised every six months based on the NSC rate. 

Floating rate funds invest in bonds whose interest rates are reset periodically so that the fund earns coupon income that is in line with current rates in the market, and eliminates interest rate risk to a large extent.

Finally, for investors looking at a higher yield from government securities, State Development Loans (SDLs) are an attractive option.

State Development Loans (SDLs) are debt instruments issued by State governments for meeting their borrowing requirements/budgetary needs.

These are comparable to G-Secs in terms of safety (just a notch lower), though the financial situation varies from State to State and hence the yields on SDLs are generally higher.

Top issuers of SDLs include Maharashtra, Uttar Pradesh, Punjab, Karnataka, Gujarat, Kerala among others.

Recently, the spread between the 10-year SDLs and the benchmark 10-year G-secs widened to 48 bps.

In an interaction with media a few years ago, Shaktikanta Das, RBI Governor had reiterated the sovereign-proxy status for bonds issued by various states, likely easing investor concern overseas about the risk and reward these instruments offer.

“SDLs (state bonds) are not risky at all. Firstly, the state governments are sub-sovereign and secondly there is an implicit debit mechanism which RBI operates on the due date of repayment, RBI automatically debits the state government account and makes the repayment. So, therefore, they cannot be considered as risky and this position has also been accepted by the Bank for International Settlements," said Das.

Final Thoughts

Current returns from both debt funds and fixed deposits are lower compared to the past.

While this might lead to a temptation to increase the risk in order to target higher returns, we would caution against this approach.

Short term investors should consider investing in debt instruments with a higher allocation to shorter maturity instruments as they would carry less interest rate risk once interest rates change direction and start moving upwards.

There are several types of government securities in India for an investor looking for the safest debt instrument with zero credit risk

These securities provide guaranteed income to help the investor align with the risk factor in your investment portfolio.

In the current market scenario, most experts are mildly bearish on government securities amid forecasts of higher yields.

Going forward, banks may not have much appetite for holding government bonds given the normalising liquidity conditions and the improving economy.

Hence forecasts for 10-year G-sec yields range between 7.5% and 7.8% towards the end of the year.

Debt could be a very lucrative space to watch out for in 2022.

Safe haven securities like G-secs could offer protection against potential stock market turbulence, which may increase as the economy moves into the later-middle portion of the business cycle. 

This could be a good time to lock in an investment in government securities at a higher yield for the long term.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

 

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