Consider G-Sec STRIPS to lock in returns for very long tenures: Experts

Since this is a nascent category to invest, there could be liquidity risk

Investors who want to invest in a sovereign-backed instrument which offers better returns than fixed deposits, may consider a product called G-Sec STRIPS (STRIPS stands for separate trading of registered interest and principal securities).

However, since this is a nascent product category, understand its pros and cons well.

Created from G-Secs 

Both G-Secs (government securities) and G-Sec STRIPS are issued by the Reserve Bank of India (RBI) and have sovereign backing. G-Secs pay investors a half-yearly coupon. An investor who invests in, say, a five-year G-Sec (coupon rate, say, 7 per cent) receives 10 coupons, and the principal at the end of five years.

These coupons and principal can be stripped into separate securities to create G-Sec STRIPS. Each of these STRIPS will pay 3.5 per cent (in this example) on maturity date, and one will pay Rs 100 at the end of five years.

The RBI auctions G-Secs. An entity, such as a primary dealer or a bank, that possesses G-Secs can request the central bank to convert them into G-Sec STRIPS.

“The seller applies a discount to each of these cash flows and sells them to customers. In effect, the customer buys a deep-discount bond,” says Ankit Gupta, founder, BondsIndia.com, a platform trying to promote G-Sec STRIPS among retail investors. Currently, retail investors can buy them online from BondsIndia.com.

Some other bond players could be offering them in private, off-line transactions.

“Another option is to go to the secondary market segment of the RBI Retail Direct platform. It has a negotiation system. You can place a buy request and buy them in a negotiated transaction there,” says Udbhav Rajeshbhai Shah, investment advisor, iFast Global Markets.

In BondsIndia.com, the minimum investment required is the face value of Rs 1,000 (the discounted price at the time of purchase would be less). Investors need a demat account.

Lock-in your returns

G-Sec Strips allow investors to lock in returns over a wide variety of tenures. “We can make these instruments available for tenures ranging from six months to 30-35 years,” says Gupta.

Investors who need a guaranteed payout after a fixed tenure for goals such as a child's college education or marriage or their own retirement can invest in them. Investing in G-Secs wouldn’t work as they don’t need regular payouts.

Being government-backed, they carry zero default risk. And by holding them till maturity, the investor can eliminate interest-rate risk.

Stripping converts each payout into a tradeable instrument. 

“The stripped coupons and the principal each become a separate security that can be traded. Investors can sell them before maturity if they want to,” says Joydeep Sen, corporate trainer (debt markets) and author.

In a falling interest rate scenario, the investor could make a gain by selling them in the interim.

Higher returns than FDs

Currently, G-Sec Strips are offering higher returns than bank fixed deposits (FDs). Ten-year G-Sec Strips are offering 7.25 per cent yield. The 5-10 year FD from the State Bank of India is offering 5.65 per cent (6.45 per cent to senior citizens).

Nascent category

This is a nascent product category. “Not many brokers are offering them. This creates concentration risk. If several brokers were offering the product, the price discovery would have been more efficient at the time of purchase and sale (prior to maturity),” says Shah.

While the wholesale segment of the G-Sec market is liquid, this doesn’t hold true for the retail segment. This will hold true for G-Sec Strips also.

Exit before maturity could create interest-rate risk. “If interest rates have moved up between your purchase and sale date, there would be a mark-to-market impact that would adversely affect your return,” says Sen.

Taxed as interest on maturity  

Gains from these instruments get taxed as interest income at maturity in the hands of investors and as business income in the hands of traders.

“Where the Strips are transferred at any time before maturity date, the difference between the sale price and the cost of the Strips will be taxable as capital gains in the hands of an investor, or as business income in the hands of a trader,” says Suresh Surana, founder, RSM India.

Target maturity funds (TMFs) have tenures up to 10 years and fixed maturity plans (FMPs) up to five years. When held for more than three years, they offer indexation benefit.

Should you invest?

Invest in G-Sec Strips if you understand the product, have a very long tenure, and won’t need the money before maturity. “If you need money in the interim, take a loan against these securities,” says Shah.