Govt bonds or bank deposits?

Previously in this column, we showed that bank deposits are important for goal-based investments as they help manage reinvestment risk. A reader wanted to know whether direct investment in government bonds are better. In this article, we show why bank deposits have an edge over government bonds.

Reinvestment risk vs. credit risk

All investments expose you to some risk. Equity investments, for instance, have high market risk. Bank deposits have credit risk — the risk that a bank may not return your deposit and/or pay interest on time. Government bonds do not run credit risk but pay interest every half year, exposing you to reinvestment risk. There is the risk of bond investments earning lower than the required return in any year, leading to goal failure.

Suppose you maturity-match bond investment with the time horizon for life goal. That is, to achieve a 10-year goal, suppose you invest in a 10-year government bond that pays 7% a year. This translates to a post-tax return of 4.9%, assuming 30% marginal tax rate. To achieve your goal at the end of 10 years, you must earn 4.9% every year on the interest income too. This is because the required return on your bond investment, referred to as the minimum acceptable return, is a post-tax compounded annual return. The issue is that you must find opportunities to reinvest the interest income at 4.9%. The risk is that you will be unable to find investment avenues if interest rates slide. Also, you must continually resist the temptation to spend the income on discretionary expenses such as entertainment and vacation.

The possibility that rates will be cut during the time horizon of life goal is high, given that most goals are typically longer than 5 years. Cumulative deposits and recurring deposits pay interest at maturity. The possibility of a large bank defaulting on its deposits is relatively low, although the magnitude of loss could be high in the event of a default.

Conclusion

You cannot easily manage reinvestment risk, but you could spread deposits across large banks to moderate credit risk. Note Deposit Insurance and Credit Guarantee Corporation insures your deposits, including savings account, to a maximum of ₹5 lakh per bank. In the end, it is a matter of which you are comfortable with — reinvestment risk (government bonds) or credit risk (bank deposits).

(The author offers training programmes for individuals to manage their personal investments)

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