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You Can Lose Money Even In The Govt. Securities

Government Securities (also known as GSecs or Gilts) are considered to be 100% safe. Since the Government is not likely to default, you can expect that
(a) the interest would be paid regularly and
(b) on maturity, you will get your principal amount back.


Despite this (practically speaking) zero risk of default, you can still lose money by investing in GSecs.

Let's see how:

As an example, let's say in Apr 2016 you buy a 10-year Govt. Bond of face value Rs.100 @7.5% p.a. coupon interest rate. The bond will mature in Mar 2025.

If you continue to hold the bond till maturity (and the Govt. does not default), you will get your interest and principal as promised. In short, it is a 100% risk free investment.

But what if you want to redeem your investment prematurely?

Naturally, you cannot return your bonds to the Govt. and take back your investment whenever you need money. Nor does the Govt. desire that your investment is locked-in for 10 years, which may put you into financial hardship.

Therefore, it is common practice to list the bonds on the stock exchanges. This enables the investors, both old and new, to trade in these bonds among themselves. Thus, the old investors can sell their investment whenever they need cash. They need not wait till the bonds mature. Likewise, the new investors can buy bonds whenever they have cash. They need not wait till the Govt. issues new bonds.

(Note: This is exactly the same as equity shares, where the companies issue shares "occassionally" whenever they want to raise equity capital. But the shares are listed on the stock exchanges, where buyers and sellers can invest / disinvest on a daily basis.)

Now comes the critical question... will you get the face value of your bond i.e. Rs.100?

Most people (mistakenly) assume that they will get back Rs.100 whenever they sell. Hence, Gilts are assumed to be 100% safe. (Unlike shares, people think that the bonds prices DO NOT fluctuate.)

But the reality is not so. In fact, all three scenarios are possible...
... You may get Rs.100.
... You may get MORE than Rs.100.
... You may get LESS than Rs.100.

Investing in Govt. Securities is NOT ALWAYS risk-free and 100% safe.

How much price your bond will fetch (mainly) depends on just one factor — what is prevalent market interest rate.

(Note: For simplicity, I am assuming that there are enough buyers and sellers in the market. So the price is NOT distorted by the uneven demand-supply scenario.)

Scenario 1: The market interest rates go up
Suppose, one year later in April 2017, you wish to redeem your investment. The market interest rates have since risen to 8%. So investors, who want to invest their surplus cash, will find that the new issues are available at around 8%. Whereas, if they buy your bond, they will earn only 7.5% interest.

Since no one is interested in a low-interest bond, you will have to sell your bond at a discount.

But how much discount?

You will have to accept a price at which the investor effectively earns 8% interest. This works out to Rs.93.75 (= Coupon Rate / Market Rate * Face Value = 7.5% / 8% * 100).

(Note: The coupon interest rate that the Govt. pays, remains unchanged at 7.5% for all the 10 years.)

So now the investor will earn the same returns of 8% whether he invests in a new bond (8% on Rs.100) or your bond (7.5% on Rs.93.75).

As you will note, no one will offer you more than Rs.93.75, because then his returns would be lower than 8% (which he can earn by investing in a new Gilt.)

In others words, due to change in market interest rate scenario, you will incur a loss of Rs.6.25 if you have to sell your GSec prematurely.

Scenario 2: The market interest rates drop
But suppose the market interest rates fall to 7% in April 2017, when you wish to sell your Govt. bonds.

Investors, who want to invest their surplus cash will find that the new issues are available at around 7%. Whereas, if they buy your bond, they will earn 7.5% interest.

Now your higher-interest bond is in demand and hence it will fetch a higher price.

So at what price can you sell your bond?

Based on the formula discussed in Scenario 1, the market price of your bond will now be Rs.107.14 (=7.5% / 7% * 100).

At Rs.107.14, the effective return will match the current market rate of 7% (7% on Rs.100 is same as 7.5% on Rs.107.14).

In other words, you would be able to sell your Rs.100 face value bond at Rs.107.14 on the stock exchange and earn Rs.7.14 as capital gains. This is in addition to the interest income.

Scenario 3: The market interest rates remain the same
Since there is no change in the interest rate, the market price of bonds too remains unchanged at Rs.100. Thus, you can redeem your investment at no profit no loss.

In short...
... if the interest rates rise, you will make a loss
... if the interest rates fall, you will make a profit
... if the interest rates don't change, you will be at par

This fluctuation in the Gilt / bond prices is commonly referred to as the interest rate risk. It is the same as volatility in the equity shares prices (except that in general the volatility is not as sharp).

By the way, this is true not only of the Government Securities. It also applies to all company bonds, debentures and other fixed income products listed on the stock exchange... including the most favourite Tax Free Bonds.

As you may know, debt mutual funds invest in all such fixed income products. And, their NAV is based on the market price of such bonds and debentures. Therefore, NAVs of debt mutual funds too change on the same lines, with the change in market interest rates. Hence, you will experience interest rate risk in debt mutual funds too.

Let's now come to an 'interesting' strategy:
Suppose there are two bonds, one maturing after 3 years and another after 10 years. In such cases, when the rates change, then the change in price of the 10-year bond will be more than the change in price of the 3-year bond. In other words, longer the tenure, the more is the movement in the bond prices.

Summarizing, therefore:
- Bonds prices change with interest rate movement
- This change is inversely related
- Longer tenure bonds will be affected more than the shorter tenure bonds.

Accordingly, it can be very lucrative to invest in long-term gilt / gilt funds (or long term bond / bond funds) when the rates are in a declining trend. However, in a rising rate scenario it is best to stick to ultra short term funds as the impact of interest rate movement on such funds is marginal.

Keep this strategy in mind and you can SAFELY make GOOD money by "correctly" timing the interest rate movements.

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