Around the world, the financial crisis has led to what is called a flight to safety. Investors and lenders want their money to be in safer assets. They don’t mind earning a little less, but they don’t want any kind of risk. In many countries, this has taken the form of investing only in securities issued by the government. In the US, the demand for government securities is such that the yield on them fell to 0.1 per cent at the height of the crisis. What that means is that the excess demand for treasuries (as government securities are called) led to such an increase in their price that the interest earning on them was effectively just 0.2 per cent a year.
In India too, investors who want the ultimate in safety can invest in government securities, and at returns that are much higher. While buying and selling such ‘Gilts’ (as such investments are called) would be cumbersome for individual investors, there are a large number of mutual funds available that invest only in government securities. Investing in such funds is a convenient way of accessing the risk-less returns of government securities. However, for someone who is serious about low-risk investments in fixed income securities, a little deeper understanding of risk is needed.
On any fixed income investment, whether it’s a gilt or a corporate bond or even a fixed deposit in a bank, there are three types of risk. These are credit risk, liquidity risk and rate risk. So far, we have we’ve been talking of credit risk, which means a risk of default. A high credit risk means that a borrower wouldn’t be able to pay back an investment at all. In government securities, this risk is generally considered to be zero. In other types of fixed income investments, this risk is higher. In any economy, government securities are considered to be the lowest risk.
Liquidity risk is the risk that you may not be able to redeem your investments quickly if the need arose. Liquidity risk isn’t something that would be called a risk in everyday language. If a bank had a fixed deposit scheme which couldn’t be broken prematurely, you wouldn’t call it a risk. However, quickly redeemable investments definitely offer more value than locked-in ones and investors generally prefer them to illiquid ones. In this regard, Indian gilts offer excellent liquidity since there’s a large and active market in these securities. Naturally, this liquidity also transfers well to mutual funds that invest in these securities. The kind of liquidity-related problems that occurred in some other types of fixed-income mutual funds recently cannot happen in gilt-backed mutual funds.
Unlike credit risk and liquidity risk, the last kind of risk, rate risk, does exist in gilts. Rate risk is generally the most difficult to understand for lay investors. Rate risk arises from changes in the interest rate that is paid on a security or a type of security. If this rate changes while you are holding a security, then its current value changes. Here’s an illustration. Let’s say you are holding a gilt that pays 10 per cent interest. At that point, if the government starts issuing fresh gilts which pay 11 per cent, then the one you are holding will be worth less. This will happen because anyone looking to invest in gilts won’t buy the 10 per cent ones unless their price is dropped so much that they effectively pay 11 per cent. This affect is obviously higher for those gilts that are a long way from maturity.
Effectively, this means that when interest rates change, the NAV of a gilt mutual fund can rise or fall. The correct thing to do is to invest only in gilt funds whose maturity matches your own investment needs. There are short-term as well as medium- and long-term gilt funds available. Long-term funds offer the potential for the highest risk and reward when interest rates change, while short-term funds offer the highest safety.
In India, as in the rest of the world, the last five years saw fixed-income investors become less and less bothered about risk. Now, as investors rush to find safe havens, one can expect the pendulum to swing the other way for a long time to come.