Earlier this month, the Reserve Bank of India’s (RBI’s) announced that retail investors will be allowed to buy government bonds and treasury bills directly. Investors would need to open a gilt securities account (Retail Direct) with the RBI.
Once this facility made available, retail investors will have access to both primary and secondary markets for buying government bonds. They can trade through aggregators such as stock exchanges and also participate in primary issuances directly through their Retail Direct account.
Why does this matter? The small investor wants safety first. Consider this: According to RBI’s preliminary estimates as of June 2020, 56 percent of household savings were invested in bank fixed deposits. Government securities (G-Sec) come with the highest level of safety – the G-Sec yield is what many analysts and market watchers refer to as the risk-free rate of return.
Investing in g-secs is more about safety than about investment returns. But investing in G-Secs is not entirely risk-free.
Interest rate risk in bond trading
Let’s suppose you buy a bond directly from the government at face value. The bond promises to pay regular interest. If you hold on to your investment till maturity, you get your principal back. So, there is no interest rate risk.
But if you decide to sell your holdings earlier than maturity, or decide to buy an already-listed government bond from the stock exchange, you face interest rate risk.
Let’s say you buy 1,000 10-year g-Sec bonds at a face value of Rs 100 each from the RBI through your Retail Direct account. For the sake of simplicity assume that the annual coupon is 6 percent; hence, you will receive Rs 6,000 as interest each year from your investment. If, say, in fifth year, there is a family emergency and you need the money, and you decide to sell your g-secs in the secondary market the exit price points may not be profitable. When you check market prices, you realise that you could get only Rs 99 for each of your bonds. Then you place your order and, thanks to its small size, it gets accepted at an even lower price of Rs 98 per bond. While the prices are hypothetical, the situation is not.
The risk of bond prices falling below their face value in the secondary markets is real and that’s part of interest rate risk.
By attempting to sell sooner than maturity, you could potentially be looking at a capital loss.
Secondary market liquidity may be low
If you wish to sell your g-secs early, given that your investment size is low, you may not find any buyers for the lot size. Or, it could even be that the bond you are holding has no buyers on the day you want to sell.
The outcome could be that you are unable to sell or that you have to accept a price lower than the face value. Once again, there is a chance of losing capital when you attempt to sell before maturity.
Costs, taxes and procedures
We don’t yet know the procedural aspects of how the Retail Direct facility will work. While buying and holding till maturity is unlikely to come at a significant cost, if you try to sell in the secondary market, you need to pay broking expenses and exchange-related costs.
If you don’t sell before maturity, the tax liability is restricted to the annual interest amount. This will be similar to the tax you pay on fixed deposit interest at your marginal rate of income tax.
Selling in the secondary market can attract a capital gains tax, too, if you sell at a price above the face value. The quantum of tax will depend on the holding period before you sell.
Remember, most of us think g-secs as long-term instruments. But government bonds also come with shorter tenures; those that mature within a year are called treasury bills. These too come with similar interest rates and liquidity risks, and a similar tax structure if sold before maturity in the secondary market. The risk is not as visible while buying and only comes up when you think about exiting.
While allowing retail investors to invest in g-secs directly opens yet another door for investors, for now, it is better to stick to gilt mutual funds. These funds are more tax-friendly, liquid and offer diversification. Besides, more clarity is required from the RBI on the procedure for buying g-secs directly.