This post describes RBI’s new Retail Direct Scheme and how you can use it to build a guaranteed income stream.
How to use the RBI Retail Direct Scheme to get guaranteed income?
Posted on 16 Nov 2021
Author: Sayan Sircar
18 mins read
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This post describes RBI’s new Retail Direct Scheme and how you can use it to build a guaranteed income stream.
📚 Topics covered:
- How does a bond purchase work?
- Suitability of direct bond purchasing
- Taxation of RBI bonds
- How to calculate monthly income
- How do Gilt bonds compare to bank FD
- How do Gilt bonds compare to Gilt funds
- Income flooring
- A worked out example
- Who should look for income flooring
The RBI Retail Direct Scheme (RDS) was launched in November 2021 to allow Indian retail investors, both resident and NRI, to buy and sell government bonds directly. The facility, via a Retail Direct Gilt Account (RDG Account), enables individuals to buy and sell Treasury Bills (T-Bills), Government Bonds (Gilt), State Government Bonds (SDL) and Sovereign Gold Bonds (SGB) from both primary (when issued) and secondary markets. The ability to buy such bonds was already there via the NSE goBid platform. In addition, some individual brokers also offered the facility. However, RDS allows selling bonds as well, in theory at least.
This facility provides access to RBI’s Negotiated Dealing System. Order Matching Segment (NDS-OM) system to retail investors for the first time to allow easy buys and sells. This newly launched facility is expected to improve the bond market’s liquidity in India and, in theory, enable retail investors to enter and exit government bond holdings. However, like everything new, retail investors should wait and watch before using the system. There are questions around how much liquidity will be available to exit these bonds.
How does a bond purchase work?
A bond is a contract by an issuer who needs money with the promise to:
- make periodic interest payments called the coupon to the investor. This interest payment is taxable at the investor’s marginal rate
- return the principal to the investor at maturity
Risks of bond investing
If interest or principal payment is delayed, the bond is said to be in default. This risk of default is called credit risk. Like all other securities, bonds trade in the bond market (via NDS-OM in India), and their price fluctuates due to demand and supply. The critical driver of bond prices is interest rates called interest rate risk. If interest rates rise, a new bond will have a higher coupon and old bonds with a lower coupon rate will reduce in price. The reverse happens when interest rates fall.
For a government bond, the issuer in the Central Government and hence these bonds, called Gilts, are free from default risk. There is, however, interest rate risk, and investors should be aware that if rates rise and they want to exit lower coupon bonds, they will have to do so at a discount. On the other hand, the opposite case may happen if an investor holds a high coupon bond and interest rates fall.
Mechanics of a bond purchase
A bond, like stocks, may be available when issued for the first time (called primary issuance, which is the same as a stock IPO) or be available post-issuance in the secondary market via NDS-OM.
A bond has three attributes that you must check before purchasing:
- coupon rate (this is paid half-yearly)
- maturity date
- market or issue price
These three numbers are used to calculate the Yield To Maturity (YTM) of the bond, assuming it is held to maturity. YTM is an indication of the tentative return you get while holding the bond. It is not the XIRR since the coupon payments are taxable, and it is not possible to reinvest the coupons at the same YTM.
The face value of a bond is the number 100, while the coupon is quoted in a percentage like 6.5%. A bond’s price is quoted using numbers like 105 or 98 vs its face value of 100. The YTM will be given using the Excel function RATE like this:
RATE(Years to Maturity,Coupon% * FaceValue,-BondPrice,FaceValue)
The coupon is calculated on the face value of the bond and not on the purchase price.
Suitability of direct bond purchasing
We will use the RRTTLLU framework for understanding how to evaluate bonds:
- Return: Return is measured by YTM
- Risk: Interest and credit risk may be present. Gilts do not have credit risk but will have interest rate risk based on their maturity. Stage Government Bonds (SDLs) have non-zero credit risk but can be considered negligible for practical purposes. There is call risk as well in case rates fall in the market and the government calls back or ‘retires’ higher coupon bonds
- Time: Investors should ensure that the bond maturity, which varies from 91 days to 100 years, aligns with their goals
- Taxes: Coupons are taxable at the marginal tax rate. Investors who do not need income from bonds should reconsider investing in bonds directly due to taxation on interest
- Liquidity: Liquidity refers to the ability to convert an investment into cash. RDS is expected to improve bond market liquidity, but investors should wait and see before investing. This page from the CCIL website will show the current secondary market status where these bonds can be sold.
- Legal / Regulatory: The RDS and NDS-OM platforms are under the purview of RBI
- Unique circumstances: Direct bonds are not suitable for every investor just because the platform exists. This post gives an example of using RDS to build a stream of guaranteed income
Taxation of RBI bonds
The taxation is identical for resident Indians as well as NRIs. The interest via coupon payment is taxable at the highest tax rate of the investor just like FD interest. The principal amount is tax free if held to maturity.
If the bonds are sold in the before maturity either via the RBI portal or secondary market then there will be capital gains or loss based on the selling price and therefore taxed accordingly. Short term gains occur if the bond is held for a period shorter than 12 months else it is long term. Short term gains are taxed at the marginal rate, like FD interest, while long term gains are taxed at 10% without indexation. You can offset these gains/losses against other capital gains as described here: How to calculate taxes from capital gains and combine them with your other income.
There is no TDS at any time either on interest or principal for residents. NRIs investing via NRO accounts will have the usual 30%+cess TDS on the interest.
How to calculate monthly income
You can use this formula to calculate monthly income from bond price and coupon rate:
Monthly income = 100 * Coupon * Investment / Price / 12 * (1 - TaxRate)
For example, if you buy a 2060, 5.5% coupon bond at a price of ₹106 by investing ₹50 lakhs then you get:
- notional value of the bond purchased = 100 * 50/106 = ₹47.17 lakhs
- interest payment every six months = 0.5 * 5.5% * ₹47.17 lakhs = ₹1.29 lakhs
- ₹47.17 lakhs back in 2060 when the bond matures without any TDS or capital gains tax
- this bond gives an income of 2 * 1.29 lakh * (1-30%) [assuming 30% tax rate] = ₹1.8L/year or approximately ₹15,000/month
Here, Investment = 50 lakhs, Price = 106, Tax = 30%, Coupon = 5.5% and hence the monthly income = 100 * 0.055 * 50,00,000 / 106 / 12 * (1 - 0.3) = ₹15,133
How do Gilt bonds compare to bank FD
Bank FDs also offer some features very similar to Gilts, with some key differences.
- Return: Return is known at the time of opening the FD. FDs either offer periodic interest payments or the cumulative option that leads to the compounding of returns. Gilts generally are not available with the zero-coupon option and do not compound returns
- Risk: FDs have limited credit risk since, under DICGC insurance, up to 5 lakhs per bank is insured. Credit risk is practically zero with SIFI Banks (SBI/HDFC/ICICI). The credit risk of Gilts is lower than that of SIFI Banks.
- Time: Bank FDs offer maturities from a few days to 10 years, unlike Gilts which have much higher maturities
- Taxes: FD interest is taxable at the marginal tax rate and should be avoided by investors in the highest tax brackets if possible
- Liquidity: All FDs can be broken prematurely after paying a penalty which is usually 1%
- Legal / Regulatory: FDs are a banking product and under RBI purview
- Unique circumstances: Investors belonging to the highest tax rates should consider FDs vs mutual funds as described in this post
How do Gilt bonds compare to Gilt funds
Gilt funds have a significantly different payout profile compared to Gilts because:
- Gilt funds continuously buy and sell Gilts. Each transaction changes the maturity profile and hence the interest rate risk of the portfolio
- the bonds are generally not held to maturity (unless it is a target date bond fund). This feature introduces unpredictability of the NAV of a Gilt fund. A Gilt fund with all bonds held until maturity will not have this issue
Gilt funds, therefore, offer unpredictable returns, unlike a Gilt that is held to maturity. The forward one year return of a Gilt fund is approximated by
(YTM - TER) - D * ChangeInRates where ChangeInRates > 0 for increases in rates and TER is the expense ratio of the fund. D is the modified duration of the fund that indicates the interest rate risk of the portfolio. Unlike a Gilt, a Gilt fund does not offer any guarantees of return of the invested amount or any profit via NAV appreciation. Investors looking for debt funds to invest in should look at this post.
Flooring is achieved if the total return from a debt portfolio equals expenses at the point of retirement. This income is held constant throughout retirement. Here the retirement horizon is defined as the start of one spouse’s retirement to the death of the last surviving spouse. The most significant risk with income flooring is that it is not inflation-indexed.
Income flooring has been traditionally achieved by investing in pension plans or annuities, as described in this post. However, unlike pensions which offer deferred payments for years if desired, interest payments for bonds start soon after investment.
If inflation-indexed income is required, use goal-based investing to create a retirement portfolio as described in this post.
A single FD is typically unsuitable for this since the maturity will be less than the retirement horizon. However, a ladder of FDs is suitable, provided the ladder spans the retirement horizon. Another alternative is an annuity, but that will not return the principal at the end of the retirement horizon. We have covered the concept in more detail in this post.
You can also use a portfolio of dividend-paying stocks if the initial dividend pay-out is equal to expenses at the point of retirement. This assumes with the assumption and consequent risk that this amount of pay-out is not impacted by future equity market movements. This concept is described in more detail in this post.
The best way to implement income flooring is to buy a portfolio of risk-free Gilt bonds with maturity equal to the retirement horizon and coupons equal to initial expenses after tax. In addition, the principal, upon maturity, can go to heirs. Bonds have two payment options: interest and principal, much like an FD. Given that bonds are long-dated and Gilts are credit risk-free, we can use them to provide decades of guaranteed income.
You should open the retail direct account in joint mode so that either spouse can continue the investment in the absence of the other.
A worked out example
We will assume that the income requirement is ₹ 1 lakh/month for 40 years. A 40-year bond is available today is a coupon of 6% and a price of 105. As the first table below shows, the investment (12 / 6% * 105 / 100) will be 2.10cr. Assuming a flat 30% tax rate, we will need to invest ₹ 2.10/(1-30%) = ₹ 3cr. For convenience, we will show three tables below for ₹ 1 lakh/month for a period of 30, 40 and 50 years using gilts.
Important: The amounts in the tables do not consider taxes and hence will need to be scaled up by multiplying by a factor of 1/(1-TaxRate%).
Pre-tax investment for 30 years holding period and 1 lakh/month income
Pre-tax investment for 40 years holding period and 1 lakh/month income
Pre-tax investment for 50 years holding period and 1 lakh/month income
Who should look for income flooring
Gilts provide the safety of return of capital and a guaranteed income stream at the cost of giving up inflation adjustment. Unfortunately, India does not yet have inflation-protected bonds, like TIPS in the US, for example. The formula for finding the amount needed to support a fixed income stream per year is:
Let X be the desired income/year. Let C be the coupon, T be the marginal tax rate and P be the bond’s price. The investment needed is INV = X / C% * (P/100) / (1-T%). On maturity, the Gilt pays INV / P * 100.
For an investor who needs ₹10,000/year for 30 years and is in the 20% tax bracket, the investment required in a 5% coupon bond with 30-year maturity priced at 115 is 10000/5% * 115/100 / (1-.2) or ₹287,500. On maturity, the Gilt will return ₹287,500 / 115 * 100 = ₹250,000.
Income flooring is not suitable for everyone. However, the following types of investors will benefit from Gilt investing.
Paying for expenses of elderly parents of NRIs
NRIs can use the coupon payments from RBI bonds, held in either their own name or in parent’s name, for funding their parents’ monthly expenses in India. NRIs will have to use their NRO account for investing in and for receiving interest from RBI/Gilt bonds.
The biggest benefit of this scheme for NRIs is that due to the government of India guarantee on coupon payments and return of principal, there is no dependency on the NRI child’s own finances after the bond is purchased. In case there is a disruption of income due to health issues, immigration or job loss, your parent’s income will continue. The interest payments that they will receive are fixed however and will not increase over time with inflation.
Read more here: How can NRIs easily manage their parents’ finances in India?
Paying a term insurance premium
The premium of a term insurance policy remains fixed over time. The insured can pay the premium as a single, one-time payment. However, that is an inefficient usage of capital since the implied interest rate on that premium favours the insurance company. Instead, suppose your financial goals are on track, and sufficient corpus is available. In that case, a gilt bond can fund the insurance payments throughout the term of the policy. You can use the principal on maturity for other goals like retirement.
This way of premium payment may not be the best usage of investible surplus for many people. Still, it can be considered under particular circumstances where there is future income uncertainty. The example in the previous section illustrates a 30-year-old taking a term plan for 30 years for ₹10,000/year. They have the option to invest ₹287,500 in a 30-year bond (P = 115, C = 5%, Tax = 20%) which pays them, after-tax, ₹5,000 every 6 months. This way, the coupon payment funds the insurance premium for the entire policy duration without taking any expensive waiver of premium rider or a single premium plan. The Gilt pays ₹250,000 on maturity, unlike a single premium plan which does not return anything.
Paying for the education of a child
Gilt investing can be used to pay for a child’s school education via coupon payments. We are assuming that the coupons are large enough to cover school fees over the entire period. You can time the bond purchase so that the maturity amount can pay for the UG college education.
Retirees with sufficient corpus
Retirees may choose Gilt investing if they have a very high corpus relative to projected long term retirement expenses. From their perspective, the product offers the simplicity of the FD and the comfort of guaranteed regular interest payments. If their yearly expenses are much smaller than the coupon payment of Gilts, then just investing in long-dated Gilts will suffice for retirement. However, suppose the corpus does not provide sufficient income. In that case, retirees should reconsider Gilt investment and follow the bucket method outlined in this post.
Windfalls are defined as a generally unexpected inflow of money from a property sale, inheritance, stock price appreciation (like stock option holders), large income tax refund or lottery winners. Unfortunately, there are commonplace examples of how windfalls lead to bankruptcies due to a lack of money management skills. Solving this problem is investing in Gilts, where the coupon payments provide adequate income and preserve the principal.
For wealth preservation
An extension of the previous situation of handling windfalls is preserving wealth for multiple decades. An example is celebrities who have amassed large amounts of wealth and need a way to keep it safe. In such cases, capital protection is paramount. Gilt investing offers an excellent option to ensure the money is not squandered in questionable investments and transactions.
Investors outside the situations described above should carefully evaluate if Gilt investments are suitable for their goals.
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