27 July 2019

G Sec – An obsolete investment category

G-Sec has delivered outstanding returns for one year investors and going by the tendency of
investor / advisor to invest in funds that show good past performance, investors are moving
towards this category.

Our view:
G-Sec is not a good investment category – neither from a short term perspective nor a long term
investment horizon.

Let us understand, why G-Sec is not good in the long-term horizon

The last one year returns for G-Sec funds has been around 14%. Now, in order to deliver similar
returns over the next 3 years, so as to get the long term tax benefit, the interest rates would have
to fall from the current level of 6.4% to 1.7% levels over the next 3 years.

The calculation of this can be explained as below:

Current Net Yield p.a. of G Sec Funds 5.8%

Cumulative Yield (Accrual) over 3 years 18%
Cumulative 3 year return @14% p.a. 48%
Capital Gain required over 3 years 30%
Modified Duration (Interest Rate Sensitivity measure) 6.50
Interest Rate fall required over 3 years 4.6%

The probability of G-Sec falling to these levels over the next 3 years is negligible. Moreover, in
the best case scenario if the interest rate falls by 2% over the next 3 years, the 3 year CAGR return
could be 9.5% p.a.

In our view, one is better off investing in a credit risk fund, as the net yield on credit risk funds as
on date is closer to 9.5%. Which means that even if the interest rate does not move, the investor
would make closer to 9.5% p.a.

Furthermore, if the investor is a short term investor and is of the opinion that interest rate will fall
over the next 6 months – 12 months, even in this case, G-Sec is an obsolete investment category.

Let us explain why G-Sec is not good in the short-term perspective

Assuming the investor makes 14% over the next 1 year, the tax rate applicable would be marginal
tax rate of 30% + surcharge and cess on both accrual and capital gain. Thus, a pre-tax return of
14% p.a. would translate to a post-tax return of 9.1% p.a.

So, while the interest rate call fructifies, the tax inefficiency would bring down the return to 9.1%
i.e. a return similar to net yield of credit risk funds.

Therefore, we say that G-Sec is an obsolete category and if one wants to take a call on interest rate,
there is a better method available since 2014 to encash the gain arising out of interest rate fall view.

Data as of Jun’ 19. Data Source: AceMF

 27 July 2019

This method includes separating accrual income and capital gain. That is you can separate the
accrual by investing in credit risk fund / accrual fund and take the interest rate view by taking
position in Interest Rate Futures.

How does this strategy work?

1. If you have a view that interest rate is expected to fall, then you should invest in credit risk
funds / accrual funds. These funds are currently offering a net yield of 9%.
2. Next, you should take a long positions in interest rate futures. You need to open a currency
account with your broker to trade in interest rate futures.
3. You would have to place a margin with your broker which is generally in the range of 3% - 5%
of the contract value.
4. The position would be marked to market daily and on maturity you can either square off the
position or roll it over.
5. So, if in 3 months, the interest rate call actually fructifies, then you only need to close the future
position and pay tax on that component, while the credit risk fund can be held on till it completes
3 years.

Our recommendation:

We recommend having a debt allocation in the portfolio with an objective of getting stable returns
and not from an objective of making speculative and instable returns. Thus, one should avoid
taking interest rate risk in their portfolio and stick to credit risk funds that benefit from high coupon
income.

Data as of Jun’ 19. Data Source: AceMF

 27 July 2019

Disclaimer:
This report has been issued by AR Wealth Services Ltd, a subsidiary of Anand Rathi Financial Services Limited (ARFSL). The information herein was
obtained from various sources; we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes an offer,
or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments").
ARFSL and its affiliates may trade for their own accounts as market maker / jobber and/or arbitrageur in any securities of this issuer(s) or in related
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position in any securities of this issuer(s) or in related investments. ARFSL or its affiliates may from time to time perform investment banking or other
services for, or solicit investment banking or other business from, any entity mentioned in this report. This research report is prepared for private
circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may
receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed
or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income
from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Past performance is not necessarily a guide to future
performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this
report.

Data as of Jun’ 19. Data Source: AceMF