Long-duration bonds: Match investment horizon with the bond's tenure

Check post-tax returns, and preferably hold till maturity to reduce interest-rate risk

Goldman Sachs’ recent recommendation for investors to go long on India’s 30-year government bonds has put long-duration government securities in the spotlight. The firm expects yields to decline from current levels due to the inclusion of the benchmark 30-year bond under the Fully Accessible Route (FAR), which could broaden demand from foreign investors.

 

Another factor that could support these bonds comes from the financialisation of household savings. Money, according to Goldman Sachs, is moving from bank deposits into long-term savings products such as pension funds, Public Provident Fund (PPF) and insurance. This shift can increase the demand for ultra-long government securities. Let us examine the suitability of longer duration funds for retail portfolios.

 

Tenure extends up to 50 years

 

Besides the 10-year benchmark G-sec 2035, bonds with tenures of 14-, 15-, 30-, 40- and 50 years are available.

 

State governments issue State Development Loans (SDLs) in similar long tenors. “SDLs offer slightly higher yields than central government securities. Sovereign Green Bonds with 10-year and 30-year tenors are also available,” says Nishchay Nath, founder & CEO, BondScanner.

 

Where can you buy them

 

Retail investors can buy these bonds directly through the Reserve Bank of India (RBI) Retail Direct platform. They can also buy them through a Securities and Exchange Board of India (Sebi)-registered online bond platform. Investors who do not want to buy individual bonds can access similar exposure indirectly through gilt mutual funds.

 

Sovereign safety, predictable returns

 

The main advantage of central government bonds is safety. “Long-duration government securities provide sovereign credit quality and virtually eliminate default risk,” says Saurabh Bansal, founder, Finatwork Investment.

 

Long-dated government securities offer a predictable and steady stream of return over the long term. “Investors who hold the bond to maturity can lock in today’s yield for the next two to three decades,” says Nath.

 

One tax-related advantage these funds enjoy is that central government securities do not attract tax deducted at source (TDS).

 

If yields fall, the market price of existing long bonds rises. “Investors may then earn capital appreciation in addition to regular income,” says Bansal.

 

The real purpose a long-duration bond serves is to allow investors to match the tenure of these bonds with a long-term liability.

 

Long-duration government securities can serve as a portfolio stabiliser in long-duration portfolios.

 

Beware interest-rate and liquidity risks

 

Government securities are free from credit risk, but not from interest-rate risk. “Longer-duration bonds can experience significant price volatility when interest rates rise,” says Bansal. The longer a bond’s maturity, the higher the price swings it witnesses.

 

“If rates rise and investors sell a 30-year bond before maturity, they can suffer a real capital loss despite holding a sovereign instrument,” says Nath.

 

“Prices can also fluctuate significantly with changes in inflation, interest rates, fiscal borrowing and global yields,” says Vineet Agrawal, co-founder, Jiraaf.

 

Another downside of these securities is that over time, inflation erodes the value of the fixed returns they earn. “A fixed coupon that looks attractive today would lose considerable purchasing power over 25 or 30 years,” says Nath.

 

Liquidity is another risk. Trading volumes are thinner in the very long end of the market. “An investor who tries to exit a 40- or 50-year bond early may find wider spreads and fewer buyers than for the 10-year bond,” says Nath.

 

Investors also face reinvestment risk on the coupons they receive. Interest income is taxed at the investor’s slab rate, which lowers the effective return.

 

Hold to maturity to reduce risks

 

One way to handle the high interest rate sensitivity of these bonds is to hold them to maturity. “Interest-rate volatility along the way matters less if investors intend to hold till maturity,” says Nath.

 

Check YTM, your liquidity needs

 

Investors should match the maturity of these bonds with their goals. The choice of tenure of instruments should be driven by financial goals.

 

Check the security’s yield to maturity (YTM). A bond’s coupon can be misleading. What investors earn depends on the price they pay, which is reflected in the YTM. “Check the YTM right before investing because it changes every day,” says Nath.

 

Laddering the maturity of these bonds can help investors avoid reinvestment risk. “This will prevent all the bonds from maturing at the same date, thereby giving rise to the possibility of reinvestment risk if rates are low at that point,” says Nath.

 

Compare the post-tax yield of these bonds with alternatives such as fixed deposits or debt funds.

 

Best for distant goals

 

Long-duration government securities suit investors with distant goals. These may include retirement income, a child’s education or marriage. “Institutional investors like pension funds and insurers buy long-dated government bonds to match long-dated commitments,” says Nath. Retail investors can use them similarly.

 

Agrawal says that in a retirement portfolio, these longer-duration bonds can fit into the fixed-income allocation that most investors make for the safety of the portfolio.

 

Retirees, those saving for retirement and conservative long-term investors may use these bonds.

 

“Investors who expect interest rates to decline over the long term may also go for these bonds,” says Harsh Vira, chief financial planner and founder, FinPro Wealth.

 

“All investors who invest in these bonds must, however, have the ability to tolerate interim price volatility,” says Agrawal.

 

Vira warns that investors with short horizons, those who may have frequent liquidity requirements, or those who lack the appetite for interim price volatility should avoid these bonds.

 

Start small, stagger entry

 

Retail investors should avoid putting their entire retirement corpus into 30-year securities. Start with a small allocation. Investors should avoid making a concentrated allocation at one yield level. “Make staggered investments to manage reinvestment risk and interest-rate risk,” says Agrawal.

 

Existing retail investors should not treat 30-year G-secs as a trading opportunity.

 

Mutual fund alternatives

 

Investors can choose long-duration gilt mutual funds or target maturity funds instead of buying G-secs directly. “Mutual funds offer diversification, professional management and easier liquidity,” says Vira.

 

Direct G-secs provide predictable cash flows if held till maturity. “They also have no fund management risk,” says Vira. The better route depends on the investor’s expertise, liquidity needs and investment horizon.