High-yielding SDL/Govt Bonds OR FDs/Debt Funds?

High-yielding SDL/Govt Bonds OR FDs/Debt Funds? Since few days I am regularly following the yield of certain Gilt and SDL. Accordingly, I used to share the yield on my social media accounts. Based on that, one of my clients asked this question. Hence, thought to answer it through the post.

This question is always popping into all the retail investor’s minds. Especially after the recent uptrend in bond yields and thanks to the RBI Retail Direct.

High-yielding SDL/Govt Bonds OR FDs/Debt Funds?

My latest tweet in this subject was as below.

Based on this, one of my clients asked the below questions.

1. Can Investing in SDLs give better returns than active or passive debt mutual funds?
2. If yes, Is it better to directly buy SDLs from RBI Retail Direct (or) invest through ‘Target Maturity mutual funds’? I read that returns from direct SDL purchases attract more tax, but Target Maturity Funds are taxed at a rate of 20% post indexation benefits.
3. Do you recommend investing in the above MFs or any other ‘passive debt funds tracking Nifty AAA Bond Plus SDL index’, over Money Market funds if my goal is planned in 2028?
4. Are the above funds better than Bharat Bond ETF?

First try to understand the features of SDL or Gilt Bonds (let us ignore the tenure for time being). They pay the coupon (interest in simple language) on regular basis. Hence, if your idea is to accumulate the corpus, then such products are not suitable for you. As they pay the interest on a regular basis, the re-investment risk or utilizing the interest for other purposes is always there. Also, today’s yield is your actual yield if you are holding it till maturity. If you are planning it to sell before maturity or accumulating on regular basis means your yield may vary (either up or down). Hence, understand the concept of yield at first.

Just because RBI is providing a platform to participate in buying Govt Bonds does not mean that one can BLINDLY jump in.

This is one aspect of buying govt bonds directly. Coming back to the risk. You are just coming out from the risk of default or downgrade as the Govt of India or State Govts are issuers. However, based on the tenure of the bond, volatility is part and parcel of such bonds. Longer the time horizon higher the volatility. Hence, are you ready to digest such volatility is the question market you have to ask yourself.

Yes, if we compare debt funds with these bonds, taxation is an issue here. Because coupon is taxed as per your income tax slab. However, in the case of debt mutual funds, they are taxed at 20% with indexation (if the holding period is more than 3 years) or as per your tax slab (if the holding period is less than 3 years. Refer the mutual fund taxation rules at “Mutual Fund Taxation FY 2022-23 / AY 2023-24“.

Hence, if you are looking for growth of your investment, then I strongly suggest you stay away from direct bonds purchase. However, if you are looking for a constant stream of income, then these bonds are the best choice (in the current scenario).

Now, if one wishes to hold these bonds through mutual funds and is unwilling to take the default or downgrade risks, then there are certain options available in mutual funds which you can utilize.

1. Gilt Funds – They invest in Government Of India Bonds up to 80%. As per SEBI Recategorization definition, the fund manager is free to invest the remaining 20% as per his or her wish. Also, as there is no clarity on average maturity and modified duration in such funds, the fund manager is free to take a call buying or selling long or short-term bonds based on the interest rate cycles. Take, for example, currently, the majority of these funds are holding short-term to medium-term government bonds. However, if the current interest rate cycle reverses then they may hold the long-term bonds also. Hence, just because currently they are holding short-term to medium-term bonds does not mean they are less volatile than Gilt Constant Maturity Funds. If you have opted for such funds, then you have to monitor the portfolio regularly and especially where the remaining 20% is going to be invested.
2. Target Maturity Debt Funds – Even though these products look fantastic mainly because of the current yield and the safety (as they either invest in Govt Bonds or PSU Bonds), you have to notice one thing that the yield of these bonds chane on daily basis. Hence, if you are investing as a lump sum then fine. However, if you are investing monthly, then yield of your each month investment will change. Hence, if you are assuming that you started investing in such target maturit funds with an yield of 7.5%, then the future monthly investments are guaranteed of such yield for you. Buying such target maturity funds is sensible when you are investing a lump sum and your requirement is matching the maturity. Avoid the target maturity ETFs which are available in the market. Mainly due to price variation and liquidity may be an issue.
3. Gilt Constant Maturity Funds – They are high in volatile as the Macaulay duration of the portfolio is equal to 10 years and as per SEBI definition minimum investment in Gsec is 80% and remaining 20% is a freedom to the fund manager.

You noticed that each option or products have their own positives and negatives. Hence, rather just chasing the yield and looking at safety of Government Bonds, investing blindinly is not a right strategy. Instead, first understand why you are exploring the debt. It is beacuse of goal is nearer or for asset allocation purpose. Accordinlgy choose the products. However, if your goal is long term, then my first preference is EPF+VPF (for retirement), PPF or SSY (for girl child education and marriage) and if you still have a room or you need certain portion of liquidity for rebalancing purpose, then use the available debt products based on the pros and cons of the products.

If you don’t know how to construct your debt portfolio, then refer my post “Top 10 Best Debt Mutual Funds to invest in India in 2022“.