Many appear to be interested in buying government bonds. You can buy such bonds by placing bids through your brokerage account. The intention to invest in such bonds is not surprising, given that they are credit-risk-free. In this article, we discuss the factors you must consider when investing in such bonds.

MAR risk

Picture this. You have lump-sum money, which, if invested at 6.5% per annum, can help you achieve a 10-year goal. So, you buy a 10-year government bond paying 6.50% per annum. The bond pays you interest every half year. The issue is that you must reinvest the interest received at 6.50% per annum for the remaining period of the goal. Otherwise, you are unlikely to accumulate the wealth required to achieve the goal. Why?

The required return of 6.5% is a (post-tax) compounded annual return, referred to as minimum acceptable return or MAR.

That means you must reinvest the interest every year at 6.5% per annum over the life of the goal to accumulate the required wealth. Government bonds do not compound interest income. You must find avenues to reinvestment the interest income. The risk is that the interest rate could dip in any period through the life of the bond (viz., reinvestment risk). That means you could fail to achieve the goal. Also, it is optimal to match the maturity of the bond with the time horizon for the life goal; you may not get the maturity appropriate for the life goal at the time you invest.

If you have a 10-year goal, there must be an auction of a 10-year bond at the time you invest. This makes investing for, say, 6, 7 or 8-year life goals difficult, as RBI may not auction bonds for such maturities. Note that interest income on government bonds is taxed at your marginal tax rate.

Conclusion

What about funds that invest in government bonds (gilt funds)? Your investment is based on the fund’s net asset value (NAV), which is the market value of the portfolio divided by the number of units. That means the fund’s NAV will decline when bonds held in the portfolio fall in price. Therefore, such investments are exposed to market risk.

Direct investment in government bonds does not have market risk; you can hold the bonds till maturity and get the par value regardless of the interest rate at that time.

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