Debt – Invest in Long Term Funds or Short Term

In 1996, IFCI came out with Family Bonds. OF the many options it provided, one that interested me and one I had my family invest was Millionaire Bonds (Option 1) with a face value of 10,000 per Bond. 

As the name itself proclaimed, an investment of Ten Thousand would result in a final maturity amount of 1 Million. The investment itself was a no brainer despite my own lack of knowledge on interest rates. IFCI being a government owned company meant no credit risk and a Million Rupees is a Million Rupees.

The bonds would compound at a rate of 17% annually and at the end of 30 years would yield the investor the final maturity value of 10,00,000.00. The bonds if they were still in force would have matured in 2026 and while a Million Rupees these days doesn’t seem as much as it was seen in 1996, it still is a solid amount. 

Unfortunately for the Investors, the Bond also had an early call option which IFCI exercised and redeemed the bond in 2003 for a princely sum of Rs.30,270. So much for the Million Dreams that got shattered.

Today when interest rates at Banks are close to 7%, a 17% interest rate of the past seems like something that may never come back. Today even 7% appears to be mouth watering when we see the interest rates in european countries where you need to pay an interest on your deposit to the bank rather than the other way around.

Unlike in 1996 when there was no opportunity to lock-in funds for decades ahead, today we have such an opportunity in the form of 30 year government treasury bonds. If you don’t have taxable income, you are able to get an regular interest income for the next 30 years.

But if you are like most employed and have a taxable income, the returns are sub-par post accounting for the taxes (higher your bracket, lower the returns). Thankfully we do have Mutual Funds which can Buy and Hold such securities while income is recognized on your books only at the time of selling.

The biggest advantage of buying long term gilt is that you are locking in the interest for the future. But this can work either way. In a falling interest rate scenario, your investment like the IFCI bond would turn out to be an amazing winner.

Yet, the risk  is as high if not higher. In neighbouring Pakistan, Core Inflation in 2015 dropped below the 4% mark. Like us, it came even as GDP growth rate fell. This was a steep fall from the  17 percent inflation that was seen in the country in the year 2007-08. Interest Rates followed suit with the Central Bank slashing the rates to a 42 year low of 7%.

Today, Pakistan Inflation of 14.6% is the highest its been in the last 12 years. While most countries interest rate is going down, the Central Bank has been forced to hike it up to 13.25% (double the rates it had seen just 5 years ago).

Mutual Funds love selling longer term funds. The expense ratio for a Medium to Long Term fund is 5 times as expensive as a simple liquid fund. Based on current assets under management, I see very little interest in such funds {Ignoring for Liquid AUM, Medium to Long Term funds have been able to capture just 0.78% of the total assets}. 

Investing in Long Term Bonds requires a view on the interest rates and is not a Buy and Hold investment for if things go bad, you will end up not having any return even after years of being invested.

Thanks to the recent downmove in Interest Rates, 1 year Gilt returns looks extraordinarily good and this is starting to show up as interest both from advisors and retail clients. Jumping in now can be beneficial if interest rates continue to trend downwards, but if they react upwards, you would be in for a really long wait.

Short Term Funds carry the risk of reinvestment at lower and lower rates if interest rates continue to go down. But if they rise, they quickly start getting higher returns since the bonds are of short tenure and reinvested at a higher rate.

For a small investor, Debt funds are and should be used as Capital Protection for the rainy day. The real growth though shall come from Equity and hence the importance of asset allocation. Trying to generate Alpha through Debt is fraught with Risks that need not be taken in the first place.