G-secs: A decent investment option provided you hold till maturity

The flip side is that while they shield you from credit risk, they aren't tax-efficient and are prone to interest-rate volatility

In the aftermath of the IL&FS fiasco, investors have become highly wary of credit risk. Many of them are thinking of investing in government securities (G-Secs), which eliminate credit risk altogether. These instruments do, however, carry other risks investors should be aware of. 

Modus operandi of purchasing G-Secs

Six months ago, NSE and BSE launched platforms to enable retail investors to participate in the non-competitive bidding section of G-Sec auctions. These auctions take place on Fridays, while those for treasury bills are held on Wednesdays. Five per cent of these auctions are reserved for non-competitive bidding that retail investors can participate in. 

Investors don’t need to open any special accounts to participate in these auctions. They can do so through their existing broking accounts. The brokerage fee that can be charged cannot exceed 0.06 per cent, or six paise for every Rs 100 worth of allotment value. 

An investor has to place an order with his broker, who will tell him the amount that must be placed in his ledger account. The broker then blocks the amount and forwards it. By the end of Friday, the Reserve Bank of India (RBI) provides the cut-off rate. On Monday, the exchange uses the cut-off rate, plus accrued interest and brokerage fee to arrive at the total cost for the investor. Any surplus amount is refunded. 

First, let us understand how the cut-off rate is calculated. Institutional participants place bids in G-Sec auctions. The RBI finalises a cut-off price based on their bids. Any institutional investor who bids at a price higher than the cut-off rate gets an allotment. “Retail investors get to purchase G-Secs at the cut-off rate determined based on institutional investors’ bids,” says Avinash Luthria, a Sebi-registered investment adviser and founder, Fiduciaries. 

Next, let us look at what accrued interest means in this context. The interest on government securities is paid half yearly. Suppose that the auction happens for an existing security, say, the 2020 G-Sec. If you buy now, in October, you will get the half-yearly interest in December. But you are not entitled to the interest for July-September. So, the accrued interest for this period has to be calculated and returned to the government. 

The G-Secs get credited to the investor’s demat account by Monday (T+1 timeline). 

The minimum investment is Rs 10,000 by face value. After that investors can buy in multiples of Rs 10,000. The maximum they can bid is Rs 20 million per auction per individual. They have to bid for a minimum of 100 bonds as the face value of each bond is Rs 100. 

Depending on demand-supply and the interest rate scenario, G-Secs sometimes get sold in the auctions at a premium or at a discount to the face value. If they are sold at a premium, the yield that the investor will earn if he holds them until maturity will be lower than the coupon rate, and vice-versa. 

IDBI Bank’s Samriddhi portal, which does not charge any brokerage, is another option that investors can consider to invest in G-Secs. 

Zero credit risk, but highly volatile   

Government securities allow investors to reduce credit risk in their portfolios. “Since these securities have sovereign guarantee, credit risk gets eliminated completely,” says Anup Maheshwari, chief executive officer, Equirus Wealth Management.

G-Secs also allow investors to lock into interest rates for a long tenure. Most bank fixed deposits have a tenure of 10 years (only a couple offer 20-year FDs). “With G-Secs you can lock into current interest rates for 30 years or more,” says Udbhav Shah, a Sebi-registered investment advisor and founder, DravyaSiddhi. 

  

The cost involved in purchasing G-Secs directly is also quite low (brokerage cost of 6 basis points plus GST). If an investor were to take the gilt fund route, he would have to pay an annual recurring fee in the form of an expense ratio. No tax is deducted at source in G-Sec transactions as they are in demat form. 

Unfavourable taxation 

The key disadvantage of purchasing G-Secs directly is the high rate of taxation. “The interest that the investor earns from G-Secs is taxed at the marginal income tax rate,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. For investors in the highest tax bracket, there is a substantial tax arbitrage available if they take the gilt fund route, where the returns come in the form of capital gains. 
 

“Investors who hold them for more than three years become entitled for capital gains to be taxed at 20 per cent with indexation benefit. This makes the mutual fund structure more attractive for them,” adds Dhawan. 
 

G-Secs are also subject to reinvestment risk. When the bonds mature, the investor may be forced to reinvest at a lower rate, if interest rates within the economy are low then. 

Liquidity could also be an issue. “G-Secs are very liquid for the institutional segment where the ticket size of deals is large, but there are very few buyers if you want to sell five or 10 bonds,” says Shah. 
 

Another drawback is that G-Secs are not eligible for the Rs 50,000 tax-free interest income, which has been provided to senior citizens from this financial year. Only interest from bank deposits and post office schemes is eligible for this benefit.

Hold until maturity

Investors who plan to invest in gilts directly must keep a couple of points in mind. In the case of longer-tenure G-Secs, the mark-to-market impact when interest rates rise can be very high. Their prices drop sharply. “To avoid intermittent volatility, G-Sec investors should preferably hold them until maturity,” says Shah. If you need money during the tenure of these bonds, take a loan against security. To curtail reinvestment risk, investors should ladder their investments, so that they mature at different points of time. 

Investors with very low risk appetite, who will not require the money during the tenure of these bonds, may invest in G-Secs. Only those in the lower tax brackets should opt for the direct route.  

Pros of investing in G-Secs

• Allow investors to eliminate credit risk
• Investors can lock into credit risks for very long periods
• No TDS applied 

Cons of investing in G-Secs

• Marginal income tax rate on interest income will hurt those in higher tax brackets
• High interest-rate volatility
• Not eligible for Rs 50,000 tax-free interest income allowed to senior citizens