Looking beyond credit risk – The Hindu

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Last month, the Reserve Bank of India (RBI) said it will allow SEBI-registered non-bank brokers to access its bond trading platform in yet another initiative to boost retail participation in government bonds. Previously,we discussed if government bonds were attractive investments. Here, we revisit this discussion from a core-satellite framework.

Reinvestment risk

Government bonds are credit-risk free. That is, you can be certain the government will pay interest and return the bond’s par value on time. But there are other factors to mull.

When you are investing for core (goal-based) portfolio, you must match the maturity of the bond with the time horizon of your life goal. That may be difficult as the RBI may not hold a bond auction matching your maturity need at the time you want to make a goal-based investment. True, you can buy a bond in the secondary market if RBI’s step to allow non-bank brokers takes off. But remember, bonds react to anticipated changes in interest rates; an anticipated dip in rate will lead to a rise in bond price and an anticipated increase in rate will lead to decrease in bond price. So, timing the purchase of bonds in the secondary market can be tricky.

Then, there is reinvestment risk. Suppose, you have to earn 4.5% compounded annual return to achieve a 10-year life goal. Simply investing in a 10-year government bond that earns the needed return will not be enough. This is because you may have to find investment avenues to reinvest the interest received as the required return is on a compounded annual basis. The risk is interest rate can dip in any year before the bond matures, and you will be unable to earn 4.5% on a compounded basis. Also, bonds pay semi-annual interest. The issue is more frequent interest payments in a year, the greater is reinvestment risk.

Conclusion

You must assume high level of reinvestment risk for eliminating credit risk when investing in these bonds. Bank recurring deposits and cumulative fixed deposits reduce reinvestment risk but expose you to some credit risk. While the decision on which investment product to choose is yours, be mindful that default on bank deposits is uncommon.

That said, if you are investing surplus cash (satellite portfolio) and do not mind the reinvestment risk, buying government bonds through primary auctions could be optimal.

(The author offers training programmes for individuals to manage their personal investments)