Friday, February 17, 2023

Investing in Gilt Funds as compared to FD

Over the last few years, I have internalised the importance of Asset Allocation in planning the personal finances, especially for long term goals such as retirement. 

Deciding Asset Allocation

There are many formulas for asset allocation that you will find floating around, but what I have realised is that your ideal asset allocation has much more to do with your your behavioural mindset than anything else. For example, it is often said that if you are young you should have most of your investible surplus invested in equities. But, if you do that without fully understanding the associated risks and the patience needed to achieve optimal returns, you may end up doing even worse than fixed deposits.

That's because we, as humans, are primarily driven by fear and greed when it comes to investments. This leads us to buy equities when they are expensive (since there is a lot of hype) and sell them when they are cheap (since there is a lot of gloom), the exact opposite of what we need to be doing. This is something that's easily said, but very hard to internalise and even harder to practice.

When you decide to invest in equities, don't just consider the amazing profits that you may get, but also think about the realistic possibility that the value of your investment may actually go down during the journey (something technically called a drawdown). There is no way to make good, consistent returns from the equities, unless you have the stomach to weather these drawdowns. And, even in recent past, there have been multiple instances where the stock market has drawn down by 50% or more.

So, how should this affect my asset allocation. Let's say my total investment is 1 crore rupees. Now, I can be aggressive and invest all of it in the equity market. Hopefully, over a long period of 10-15 years, this will give me very handsome returns. But, let's consider the negative scenario. Let's say the stock market crashes by 50% the very next year. So, my total investment shrinks to 50 lacs. I must think about how I would feel about that if and when that happens. Would this cause me to be depressed? Panicked? Lose sleep? In most people, it would do at least one of these. 

Consider an alternate approach where I come up with an asset allocation of 50:50 in debt and equity. Then, my debt allocation will only go up in value (albeit at a slower rate than equity in the long term). So, if the stock market crashes by 50% next year, my total investment will shrink to 75 lacs (instead of 50 lacs). This, though still a cause for concern, is a much easier scenario to deal with than the earlier one. If even this appears like an alarming drawdown to you, your ideal asset allocation needs to be even lighter on equity.

In other words, consider the maximum drawdown that you are willing to tolerate when you come up with an ideal equity allocation for yourself. For example, if you don't want to see your net worth go down by more than 20%, your equity allocation should be no more than 40%. This is really the risk reward tradeoff that you need to consider.

For myself, I decided that a 50:50 asset allocation is something that I feel comfortable with. Though, even 20% drawdown in stock markets (which is not very uncommon) seem very painful at times.

Debt Investment

This then brings the other question of where should the debt allocation be invested. Note that the main purpose of debt allocation is safety, that it never goes down in value,  and earns a steady fixed income. Fixed deposits are the first thing that comes to mind, but your deposits in any bank are only insured up to 5 lacs. In case the bank defaults (which has been known to happen even in recent past to some banks), you stand to completely lose any amount over 5 lacs that you have deposited. Even though this may be a rare possibility, it doesn't give me the peace of mind that I need with my debt investment.

This is what prompted me to look closer at government (or sovereign) bonds. These bonds are issued by RBI, and guaranteed by the government of India, without any limit. This is literally the safest investment that you can make in the country.

Although, the FD interest rate is typically 0.5-1% higher than the government bonds, and these bonds can not be encashed prematurely either. This is where gilt mutual funds enter the picture. Gilt mutual funds provide you an easy way to buy the government bonds, and also provide much better liquidity. Also, if you hold the gilt mutual fund for longer than 3 years, you get the benefit of long term capital gains (which is taxed at 20% after indexation). This makes even the post-tax returns better than typical FDs.

Gilt Mutual Funds

So, for investments longer than 3 years, gilt mutual funds seem to be the safest and most tax efficient debt option. I see broadly 3 types of Gilt mutual funds in the market:

  1. Constant maturity gilt funds: These try to maintain a fixed maturity duration, typically 10 years. Hence, you are always subject to volatility due to interest rate changes. You need some expertise to navigate these.

  2. Actively Managed Gilt funds: These are actively managed by the fund managers, and the maturity duration varies widely based on the calls taken by the fund managers. Here, you are trusting the expertise of the fund manager to take timely actions, and provide best returns. You still will be affected by the volatility due to interest rate changes, though it may be lower if the fund manager is any good.

  3. Target maturity gilt funds: These funds have a fixed maturity date (not duration). With these, the fund value can vary in the short to medium term, but if you hold it till maturity, the returns are very predictable. In this sense, this is closest to an FD where you know the duration and return upfront, but the risk is lower since it consists of sovereign bonds. Also, if you hold for more than 3 years, effective tax is much lower too.

I personally am inclined towards gilt funds because I prefer absolute safety for my debt investments (for risk I already have equity investments!!). And within gilt funds, I prefer target maturity funds, because the other categories again carry interest rate risk.

Update: Debt funds no longer have the tax advantage effective April 1, 2023. Debt funds are now taxed as ordinary income irrespective of the duration of investment.