Are gilt funds as good as bank fixed deposits?
Many investors don’t understand that the default risks for gilt funds are almost nil while that of bank deposits is higher. Here are the details on gilt funds.
For most Indians, their first investment is often the bank savings account followed by fixed deposits. Fixed deposits are synonymous with safety, liquidity and convenience. It is simple to open a fixed deposit account at a bank where you have a savings account. You can link your savings account to your fixed deposit account. All these features have made fixed deposits popular in our country. However, given the recent problems of banks such as the YES Bank fiasco, gilt funds might actually be much safer than bank fixed deposits.
What are gilt funds?
Gilt funds are debt mutual funds that invest in government or government-backed securities. The government used to issue the bonds in golden-edged certificates. The nickname gilt comes from gilded edge certificates.
How are gilt funds better than deposits?
There are five points that an investor should note that makes gilt funds superior to bank deposits.
The first aspect is safety. Gilt funds are sovereign because they invest only in the Government of India securities. Gilt funds don’t invest in securities other than government bonds, such as corporate bonds. The government securities could be central government securities or it could be state government securities.
However, they are all only government bonds. Gilt funds do not invest in rated securities that have credit risk, not even AAA ones. So, the money that you invest will be put in only government securities where the default risk is zero. However, bank deposits are guaranteed for only up to Rs. 5 lakhs even if you have several deposits in different banks or branches. There are risks of default by the bank in case there are any solvency problems for the bank. So, while gilt funds are sovereign investments, bank deposits come with an amount of credit risk.
Gilt funds have high liquidity. This is because of the ample demand for government bonds from institutions such as mutual fund houses, banks and insurers. In the debt market, government bonds are the most liquid of all the securities. Not only banks and mutual funds, even pension funds, trusts and Foreign Institutional Investors (FII) buy government bonds. So, there is no question of illiquidity for government bonds.
Better interest rate transmission
Gilt fund returns are derived from the movements of the market. Government bond is a market-driven financial security. So, generally gilt- funds are far more efficient than bank fixed deposits, especially when interest rates start increasing. When the Reserve Bank of India (RBI) starts to increase interest rates, government bonds reflect the rates much earlier and better than banks. Banks are very slow in passing on higher interest rates to depositors while they are quick to lower deposit rates. In fact, government securities often provide slighter higher rates than those of deposits.
Bank fixed deposit rates were about 7% a year back. Three years back, the interest rate for a three-year deposit was only 6.25% while five year back, deposit rates were 7.25%. Now, if you consider gilt-funds, they have given investors more than 9.9% in the past year. Their annualised returns over the past three, five and ten years is more than 9%. So, gilt-funds have provided returns that are much higher bank deposits if you are investing for the long term.
Bank deposits are taxed as per your tax brackets. If you fall under the highest tax bracket of 30%, then, bank deposits provide lower tax adjusted returns for you. However, gilt-funds provide better returns if you stay invested for the long term. Short-term capital gain (STCG) for gilt funds (when you hold the fund for less than three years) is as per your tax bracket. However, long-term capital gains (LTCG) will have a lower tax of 20% along with indexation benefits. The effective tax rates for most investors is often much lesser than 10% if they stay invested in gilt funds for more than three years. So, gilt funds are much more tax efficient when compared to bank deposits.
What about the volatility in gilt funds?
Even though gilt funds come with interest rate risks, the risks actually help provide higher returns. How? If you have a gilt fund and the interest rates increase from 6.5% to 7.5%. Then, you will see a drop in the Net Asset Value (NAV) of the fund. However, from that day onwards all the government bonds held by the fund will get re-invested at 7.5%. So, you will get more returns from gilt funds if you remain invested for the long term.