The El Dorado Of Retail Gilts

Updated: Jan 29 2003, 05:30am hrs
Since the early 1990s, the objective of the authorities was to develop a market for government securities beyond the captive mandatory investments by banks, provident funds and insurance companies. With the move to near market-related rates of interest, captive investors started investing on a voluntary basis much more than the prescribed levels. Significant diversification was achieved as mutual funds and corporates also voluntarily invested in government securities. It was felt that a market with players with different needs and different perception would bring about the much needed stability. In 1995-96, the authorities developed a new instrumentality of dedicated gilt funds with liquidity support from the Reserve Bank of India (RBI) to develop a retail segment. The purpose of dedicated gilt funds was to encourage small individual investors to participate in the gilt market via dedicated gilt funds. While dedicated gilt funds did take off, there were certain miscued policy decisions.

There was a problem of small provident funds, co-operatives and other small institutions which were having difficulty in investing in the wholesale debt market in which the minimum deal size was large. Managers of dedicated gilt funds concentrated on institutional investors rather than individuals.

What was more unfortunate was that the tax regime totally misfired as concessions intended for individual investors in gilt funds were lumped along with other investments. When the authorities decided to free investors from the dividend tax, equity mutual funds gained while gilts funds were discriminated against. The restoration in the budget of 2002-2003 of the status quo ante prior to 1997 on the dividend tax somewhat restored the balance, but the tax concession for investment in gilts was ineffective for other reasons.

With a view to encouraging wider participation of all classes of investors, including retail, the government of India, RBI and the Securities and Exchange Board of India (Sebi) have recently introduced a scheme of trading in government securities through a nation-wide, anonymous order driven, screen-based trading system of the stock exchanges, in the same manner in which trading takes place in equities. This system will be in addition to the present system of dealing in government securities through the Negotiated Dealing System of the RBI. It is felt that this will provide a wider investor base, and reduce time and costs in trade execution by matching orders on a strict price-time priority. It is also expected to enhance the operation and informational efficiency of the market as well as its transparency, depth and liquidity. The authorities put out a draft scheme towards the end of December 2003 and then quickly implemented it in mid-January 2003.

Banks and primary dealers have been directed in no uncertain terms to be active players in this newly developed segment of the gilt market. These players would no doubt set up the infrastructure for retail trade. The painstaking efforts of the authorities need to be commended but the crucial question is whether genuine retail investments in gilts will really take off. Dr R H Patel, an ardent advocate of the new system of trading, though strongly supportive of the scheme, is rightly of the view that the individual small retail investor would not, at the present time, be attracted to the gilt market.

A long-term investor would find current gilt yields unattractive. The yield curve is flat and long-term investments in gilts would be unwise. Investors must remember the horrors which their grandfathers faced by investing in the 3 per cent Conversion Loan floated in 1946 and redeemed in 1986. Are we to believe in todays interest rate structure

Adjusted for interest rate differentials, short-term gilt yields in India compare well with the US and UK yields but the Indian long-term rates are totally unsustainable. (See chart)

An investor must believe that very low inflation rates are here to stay in India and interest rates will remain low in the long-run. If one has faith in this theology, it would make sense to invest in gilts. But if one has doubts, it could deter investors from investing in gilts. Retail investors can take a view that downward movements of interest rates would continue. But such brave investors would need to be nimble and exit in time. Most individual investors would lack such dexterity. Hence, at the present time the retail market in gilts is not really a safe investment for individuals.

Dedicated gilt funds appear to be the poor relative in the firmament of the governments largesse.

An investor would be better off investing in the five-year 8 per cent Relief Bonds and after the quota is filled, the six-year 7 per cent Savings Bond, both of which are tax free. Though bank deposit interest rates have tumbled in recent years, they are relatively no less attractive than gilts.

A number of measures need to be taken. First, the five-year 8 per cent, Relief Bond and the six-year 7 per cent Savings Bonds should be discontinued. This would require that privileged islands of investors should no longer be protected.

Secondly, for the retail trade in gilts to take off, there should be no tax on the dedicated gilt funds and individual investors income from gilts should be also tax free. Given the emerging bias in favour of equity and the antipathy towards debt funds, such a relief is unlikely.

Lastly, the government must give up its obsession with low interest rates. The present macro policymakers believe that low interest rates are a panacea for the burgeoning fiscal deficit and that infrastructure needs low interest rates. It is unrealistic to expect the government to give up these cherished objectives merely to develop the retail segment of the gilt market.

The upshot of all this is that while the platform for retail gilt investments has been built with meticulous care, the overall environment will render this unused. Investment advisers must have a heart and not lead gullible individual retail investors up the garden path as any increase in interest rates would inflict crippling losses on investors. The truthful message for individual retail investors is beware of gilts at the present time. The infrastructure for retail gilt investment has been built with care but the retail segment cannot get going till overall interest rate policies change.