Most people consider GSecs or Gilts, as the Government Securities are commonly referred to, as absolutely safe and secure.
In general, the Government will not default either (a) in paying you the interest on the due dates or (b) in repaying you the principal invested at maturity.
Well, you could be wrong, if you believe so!
Even though the risk of default in GSecs is practically absent, there are still good chances that you may incur a loss by investing in Govt. Securities.
An example will best illustrate this point.
Suppose in Apr 2016 you invested in a Govt. Bond with the following parameters:
– Face value: Rs.100
– Amount invested: Rs.1 lakh
– Rate of Interest: 7.5% p.a.
– Tenure: 10 years
– Maturity: Mar 2025
Assume you hold this investment for the next 10 years till the bonds mature and the Govt. does not default. Then, every year you will receive interest of Rs.7500. And, on maturity you will get back your principal amount of Rs.1 lakh. In other words, it’s a 100% risk-free investment.
The problem arises if you wish to exit from this investment before maturity:
Of course, unlike a Fixed Deposit, you cannot go back to the Govt. and ask them to return your money whenever you want.
But, the Govt. does not want to inconvenience you by locking-in your investment for 10 years. So, it provides you with an exit option. This is achieved by listing the Govt. Bonds on the stock exchanges. This creates an avenue for the investors to trade among themselves. In fact, it is exactly the same as buying or selling equity shares on the stock exchange.
New buyers can ‘anytime’ buy Govt. Bonds from the old investors without having to wait for the Govt. to issue new bonds. Likewise, old investors can ‘anytime’ offload their investment without having to wait till the date of redemption.
However, the key problem here is that… you may NOT get the face value of your bond i.e. Rs.100.
It is mistakenly believed that you will get back Rs.100 whenever you sell your Govt. Bond. No. Just like equity shares, bonds prices too fluctuate (maybe not as much as the shares, but still the volatility is quite significant).
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.
The reason behind this volatility in bond prices is the market interest rate, which fluctuates.
Let’s see how your Bond price is affected by the day-to-day interest rate movement.
Scenario 1: The market interest rates go up
One year later in April 2017 the market interest rates have risen to 8%.
Investors, with surplus cash, will find new issues available at around 8%. Since your Bond is @7.5% interest rate, they won’t buy your bond.
The only option for you is to sell 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).
So, now the buyer 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). You won’t get 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, here you will lose Rs.6250 (and get back only Rs.93,750 out of Rs.1 lakh invested) due to change in market interest rate scenario if you wish to prematurely sell your investment.
Scenario 2: The market interest rates drop
What if the market interest rates fall to 7% in April 2017?
Now your Bond will be in demand as the new issues are at 7% rate of interest, whereas your Govt. Bond offers 7.5%.
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, your sale proceeds would be Rs.1,07,140 and thus you will earn Rs.7140 as capital gains. More importantly, 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.
… 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.
Concluding, default risk is not the only risk that a Bond is susceptible to.
There is another risk — interest rate risk — which can cause a loss to your investment in Govt. Bonds. In fact, it is both a risk and an opportunity. By correctly “timing” your investment, you can (a) minimize the risk of losing money and (b) earn double income i.e. interest + capital gains from your investment in Govt. Bonds.