The article was first written in May 2015. Since then yield came down crashing and long-term gilt funds delivered great return. The yields have changed since then and there is upside risk and hence, one needs to prefer short term govt bond funds. I am reposting this, just to clarify few conceptual points that many people are unaware about.
We are looking at medium to long term gilt funds that invest mainly in bonds issued by the government bond. These bonds are default free and hence there is negligible risk of loss invested capital if held to maturity. Over the last few weeks, government bond yields have gone up (around 8% level from 7.7% few weeks ago). This gives good opportunity to invest in these funds to people who are fixed deposit investors as these funds should be able to deliver higher post-tax as well as pre-tax return.
I am going to illustrate this through an example. We can find better medium and long term gilt funds here. I am taking the example of
What return to expect over the next 3 years from this fund? When we look at the portfolio of this fund, we find its modified duration of 8.95 and its yield to maturity is 7.90. This means that should the yield remain the same, we will roughly get 7.9% every year( assuming the portfolio characteristics remain the same). However, RBI is looking to cut rates and it wont be amiss if bond yields fall by 90 to 100 bps (100 bps is 1%) over the next three year. A rough calculation about total returns is below: Total Return = Yield to maturity * time (years) + modified duration * fall in bond yield Total return = 7.9% * 3 + 8.95* 1% = 32.65% So if we invest, 1 lacs, we will get 1.3265 lacs, annualized return of ~9.87%. If we look at the term deposit rates of State Bank of India, we will get 8.25%. This means that we will get 1.27 lacs after three years. So, debt mutual funds will deliver 5000 rupees more.
What about post-tax return? Assuming that one is in 30% tax bracket, debt mutual funds are even better as these are index and the tax rate is even less. Assuming the average inflation will be 5.5% for next three years, indexed cost of 1 lacs is 1.17 lacs. So the long-term indexed capital gain is 15.65 lacs. The tax rate will be roughly 23% on this, which means a tax of 3600. The post-tax value of debt mutual fund will be 1.29 lacs. Compared to this, the fixed deposit amount will be roughly 1.18 lacs.
A difference of 11000 on investment of 1 lacs. What other benefit is offered by debt mutual fund. The biggest benefit is liquidity. In most fixed-deposits, there is some penalty for pre-mature withdrawal of money. There could be an exit load of 1% in some funds but the exit load is mostly zero if you hold the investment for more than 6 months. In fact for the above mentioned fund, the exit load is zero.
What is the risk? The risk is that inflation goes up and RBI is unable to cut rates. The bond yields go up. In the worst case, bond yields go up by 100 bps. Even in that case, we will not suffer loss. Our return, though will decline. One should expect a total return of ~15% in that scenario. The key point is, even the worse case scenario, there wont be any loss of invested amount. Disclaimer: The above article and calculation is for information purpose only. This is based on certain assumptions which may be different from reality and hence actual return may differ. Make your investment decision in consultation with qualified advisor.