The 10-year benchmark government security (G-Sec) seems to be losing its pride of place as the preferred risk-free bond. Or so it appears from the performance of other gilts in the past decade, right through the financial crisis.
An analysis shows the CRISIL Gilt Index, represented by a dozen liquid G-Secs, has consistently beaten the returns of CRISIL 10-year Gilt Index, which tracks only the performance of the benchmark bond.
As the accompanying table shows, in the last 14 years not only did the CRISIL Gilt index outperform the CRISIL 10-Year Gilt Index by 125 basis points, it also gave higher returns in 12 out of those 14 financial years.
What’s more, the 12 papers have outperformed by around 81 basis points (bps) for the current financial year (till 31 Oct 2016). Together, these dozen papers have accounted for a whopping 87% of the total traded volumes in government securities.
It would appear at first that liquidity premium would be the primary reason for the underperformance of the 10-year benchmark. To be sure, it is the most liquid issue around, with the trading volume tantamount to 23% of all outstanding government securities. Also, for the last four auctions the 10-year benchmark was issued at an average of 23 basis points lower than average yield of other securities of similar risk profile.
Liquidity premium is the higher price paid (and, hence lower returns/yield obtained) to compensate for easier entry and exits. Conversely, an illiquid security would trade at a lower price—or higher yield, hence a scope for higher returns. The average liquidity premium for the 10-year benchmark has been around 13 bps. In other words, the current market scenario underscores that the investor was aware returns on the 10-year benchmark would fall short on average by 13 bps because of the liquidity premium, resulting in lower accruals.
This has eaten into the returns of the 10-year benchmark, while the top 12 government securities have delivered a net outperformance of 68 bps even after adjusting for a liquidity premium of 13 bps from the outperformance for the current fiscal, i.e. 81 bps.
This may be attributed to growing market interest in these securities, which led to a favourable yield movement compared with the 10-year benchmark. Since April 2016, the 10-year benchmark yield fell by 57 bps even as those on other papers represented by CRISIL Gilt Index fell 78 bps, thus leading to outperformance. This worked in favour of the index resulting in higher capital gains (4.26%) as compared to the 10-year benchmark (3.79%).
To sum up, the message to investor is clear: Investing in G-Secs is all about liquidity and yields. The dozen bonds that make up the CRISIL Gilt Index have scored well on returns, even after adjusting for liquidity.
The author is director, CRISIL Research. Views are personal