A reader asks, “Which among the following two has higher credit risk? 1. Gilt fund (actively managed) or 2. FD in a nationalized bank? I need to choose one for a 10-year goal for the debt portion”.
On the face of it, this might look like a trivial question to at least experienced investors. However, it may be instructive to discuss this by including all possible risks instead of immediately being dismissive.
There are three major risks:
- Credit risk (in this context, it also includes concentration risk)
- Volatility risk or return uncertainty risk
- Value preservation risk.
1 Credit risk: There are two questions to consider. (a) What is the chance of a gilt fund suffering credit downgrades or defaults? (b) What is the chance of a nationalized bank getting into trouble, or what is the risk if I put all my money in nationalised banks (or concentration risk)?
(a): First, let us assume that gilt bonds will not default. This is a reasonable assumption to make. If they do, the country will be in big trouble, and we would have much bigger problems to worry about, such as everyday existence.
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Second, we should recognise that a gilt mutual fund is expected only to hold 80% of gilts. The rest can be any type of bond that can default. That said, it is a reasonable assumption that gilt funds will not get into such gymnastics and keep their portfolios reasonably style pure: gilts + money market instruments.
(b) Nationalized banks will often get into trouble, but the government will likely bail them out. The RBI has included HDFC, ICICI banks, along with SBI in the “systemically important and too big to fail” category.
As long as the money is in such a bank, the credit risk in a gilt fund (over ten years) is higher than “big” bank.
2 Volatility Risk: This is easy. There is zero return volatility in ten-year FD as opposed to significant volatility in a gilt fund. In addition, since gilt funds behave like dynamic bonds, there is significant fund manager risk also in a gilt. This adds to the return volatility.
Before tax, what is the probability of a gilt fund beating a 10Y FD? It is incorrect to speak of probability when it comes to capital markets because all possible future outcomes are unknown. Although it may not happen, it is reasonable to expect a gilt fund to beat a 10Y FD before tax.
Note: One may opt for shorter duration FDs, but those would be subject to reinvestment risk. That is, the interest rate after maturity may be lower.
3 Value preservation risk: A bank FD is taxable every year. A mutual fund is only taxable on redemption. Also, the tax rate (20%) is lowered due to indexation. Over ten years, this can be significant. For an example, see: Taxation of international mutual funds explained with an example (debt funds, gold funds and international funds are taxed in the same way).
So we would lose more of our investment to tax in an FD. That is the price to be paid for zero volatility. This increases the chances of a gilt fund outperforming an FD after tax over ten years.
Finally, a ten-year goal will have some equity exposure (at least initially), and this needs to be rebalanced from time to time. An FD is ill-liquid and cannot be redeemed mid-term without penalty.
So, over ten years, fixed deposits are only for those investors who do not mind paying higher tax for a guaranteed sum. Investors who desire lower tax and lower volatility than gilt funds can consider corporate bond funds or banking and PSU funds. However, the credit risk is much higher in these funds. See, for example: Can we use HDFC Corporate Bond Fund for long term goals?
Ps. In principle, the corporate bond option for Tier 2 NPS (for those who NPS Tier 1) can also be considered for a 10-year goal as an alternative to gilt funds. However, Tier 2 taxation is unknown. The finance ministry has not yet clarified this. Without such clarification, one cannot assume they will be taxed like debt funds. Therefore we do not recommend this option. Also, see: Can I use NPS Tier II as a low-cost index fund?