Using RBI Retail Direct for bond investments is safe but not tax friendly

Anything that comes with a ‘government’ or ‘RBI’ tag automatically gets registered as ‘super safe.’ And rightly so. The government and the Reserve Bank of India are the safest when it comes to getting backing for your investments – what’s called sovereign guarantee.

Until a year ago, the only option for small investors to invest in government paper was through debt funds and brokers. Now, the RBI has jumped into the mix to provide a direct platform – RBI Retail Direct – for investors to tap government bonds directly.

The RBI Retail Direct platform is a solid option if you want to invest in and hold Central and state government bonds directly. But bonds, in general, are difficult to understand for retail investors when you consider the dynamics of interest rates, tenure, and credit risk. More so if you buy bonds via the secondary markets and without any intention of holding them till maturity.

Let’s see whether the RBI’s new platform is a good option for small investors. First, a refresher on what this whole thing is.

You can now buy and sell government bonds directly via the RBI Retail Direct (RRD) platform. There are four types of securities available:

1. Treasury Bills (T-Bills) of the Indian Government – These are short-term debt instruments issued by the Government of India for tenors of 91 days, 182 days, and 364 days.

2. Government Bonds (G-Secs) – These are long-term debt instruments (ranging from one year to 40 years) where the Central government borrows money from investors.

3. State Development Loans (SDLs) – These are long-term debt instruments (more than one year) issued by state governments (not the Central government) to borrow for one year or more.

4. Sovereign Gold Bonds (SGB) – You can buy gold bonds too on the RRD platform.

The platform allows you to invest in all these securities directly through the primary market when they are issued or through the secondary market when other investors are willing to buy/sell existing bonds.

The biggest benefit of the platform is that it first gives you peace of mind of dealing directly with the government and getting sovereign-backed instruments for investments. So you are more or less sure that you will get your interest payments on time as it’s the government, after all. In addition, it is extremely low cost as there are no charges to open this account.

Government bonds can also be useful if you need regular income over the long term and want to set a reliable, guaranteed floor for your income – say, for 10 or 20 years. Buying government bonds for the specified residual duration can be quite useful.

But there are a few dampeners as well, which one should remember before deciding whether to invest through this platform or not.

These are not the problem with the platform but with the policies and the structure of the Indian bond markets:

· Lack of liquidity – If you want to hold your bonds till maturity, then it’s fine. But if you want to exit before the maturity date, then it can be an issue due to lack of liquidity in the secondary market.

Let’s say you buy a 10-year bond that is traded heavily today. But if you want to sell it at the end of the sixth year and liquidity has dropped off over the years, then you may find it very difficult to exit or may even have to resort to distressed sale in times of financial emergencies.

So for all practical purposes, it’s better to be prepared to hold your bonds till maturity and not depend on secondary market liquidity (as of now). Better to match the residual tenure of the bonds you are buying with the timelines of the goal that you need money for.

· Poor taxation benefits – This is a big showstopper. All government bonds available for retail investors pay interest periodically. There is no cumulative option. So as you get the interest, it is added to your regular income and taxed at your income tax slab rate every year. Compare this with simple debt funds (say gilt funds that invest in government debt only) where you don’t pay tax until you sell and also if you hold for three-plus years, your returns get indexation benefits and are then taxed at 20 percent. So your tax outgo is reduced substantially in debt funds. In mutual funds, your coupon interest gets accumulated and increases your net asset value and hence, increases returns. So with no tax incentives to invest via the platform, your returns are reduced due to unfriendly taxation.

Should you invest through RBI Retail Direct?

The word ‘retail’ is the key here. If you are a small retail investor, then its utility in your financial portfolio isn’t much. You can easily manage your debt portfolio first using traditional options such as employees’ provident funds, public provident funds, senior citizen savings scheme, and Pradhan Mantri Vaya Vandana Yojana, apart from a few categories of debt funds and Target Maturity Funds.

Agreed that G-Secs don’t carry any credit risk, but all these alternatives offer a better post-tax returns. Additionally, you can easily create a maturity ladder using a few of these instruments to align them with your cashflow requirements.

RBI Retail Direct is a great initiative by the government. But given the nascency of the bond markets in India and the understanding of the bond markets among the retail population, it might take more time to get mainstream. And given the current level of participation on the platform, the government might be thinking about ways to attract more retail investors. Offering tax incentives, at least similar to those of debt funds, is something that could be considered.