Using sovereign gold bonds for goal-based investing

I am not proud of this, but I have mostly been ignoring the advice to “look before you leap” when it comes to investing. My typical investment journey goes like this: I see some arguments for investing in some asset; I jump right into investing in it; a few months later I decide I don’t want that asset; then I figure out how to course correct. It happened with gold. It happened with Nifty 50. It may probably happen with active equity funds in the near future.

This blog post is about another such story.

Accumulating gold

When I decided to remove gold from my investment portfolio, I thought that investing in equity+debt was a good way to accumulate purchasing power to buy gold in future. If equity appreciates more rapidly than gold does, I thought, investing in equity was better than investing in gold.

But now I have a different point of view. If the end goal is to buy gold, accumulating gold slowly over time is likely a better approach than investing in equity.

The goal based investing framework recommends taking just enough risk to meet our financial goals. You don’t put all your money in fixed income because it’s going to be very difficult to retain your money’s purchasing power that way. You need to take more risk. So you add equity to your portfolio. But you don’t hold 100% or 80% equity for long since the added volatility can make it difficult to meet your financial goals. An investor following the goal based investing framework would start with relatively high equity exposure, but regularly keep reducing equity exposure to progressively reduce risk.

Investing to buy gold is tricky. Gold is just as volatile as equity is. But if equity prices fall, gold price may rise and vice versa. Gold’s price appreciation is also usually faster than fixed income’s growth. Given these, holding equity and/or fixed income assets to eventually buy gold sounds risky. it’s arguably less risky to just buy [investment] gold and hold it until we need to buy [consumption] gold. At the time of buying gold for consumption, we can sell the investment gold, and we’ll have just enough money. By holding gold as investment, we nullify the impact of gold’s price volatility.

Using sovereign gold bonds to accumulate gold

Sovereign gold bonds (SGBs) are issued by the Reserve Bank of India (RBI). These bonds have a fixed tenure of 8 years. A bond that was issued on 1-May-2021, for example, will mature on 30-April-2029. Each bond represents 1 gram of gold. On maturity, the current price of gold will be paid to the bondholder. If gold price had appreciated in these 8 years, the bondholder need not pay any tax on the capital gain, which is a good incentive for most people.

Indian weddings make use of gold. A nontrivial amount of gold is needed if you are the bride’s side. (The groom’s side usually doesn’t need as much gold.) I roughly know when our girl children will get married, so it’s easy to tell how much gold we’ll need when. In my investment tracker spreadsheet, I plot the maturity of our SGBs as a graph like this:

This graph tells me how many of our SGBs mature in a given year. This gives me clarity on exactly how much gold we can buy in that year. Accumulating SGBs is a convenient and less risky way to accumulate gold if the end goal is to buy consumption gold.

Don’t let attractive XIRR figures fool you!

Have you come across investment opportunities that quote very attractive XIRR numbers? Have you been tempted to invest in those just based on the XIRR? This blog post is for you—to discuss what XIRR means in a practical sense.

An example to understand XIRR

Let’s say I borrow ₹10,00,000 from my bank at 10% per year interest, which I promise to pay over the next 60 months. The bank will ask me to pay ₹21,247 every month. Assuming I pay exactly ₹21,247 every month from November 2023 through October 2028, I would have paid a total of ₹12,74,820. While quoted “interest rate” is 10.00%, the XIRR of this loan is 10.46%.

Let’s say I am able to pay this loan off more aggressively. If I pay ₹5,000 more every month—i.e. I pay ₹26,247 every month—how much will I save? Based on Fisdom’s calculator, I’ll be saving ₹66,689 in interest overall. The loan will be closed in 47 months instead of 60.

If I follow the original schedule, the bank receives repayments at the XIRR of 10.46%. Now that I am more aggressively repaying the debt, the total interest I pay goes down, but the XIRR increases to 11.31%!

What does this mean? A higher XIRR does not necessarily mean higher overall earnings.

How is this information practically useful?

Does this mean XIRR is a misleading metric that we should just ignore? Not really. XIRR takes into account the “time value” of money. A higher XIRR is useful to those who can optimally reinvest all the cash flow coming to them, as it is coming to them.

A higher XIRR is useful to a big bank since they can take this cash and lend to another borrower. A higher XIRR will mean the bank’s loan book can grow faster. However, if you, a retail investor, tend to simply accumulate the repayments in your savings bank account, the higher XIRR is often bad for you.

How to decide about high XIRR investments?

Some investment products show their high XIRR return prominently everywhere. If you calculate the CAGR return of the same investment, the rate may be low. But because the XIRR looks a lot more attractive, they promote the investment by quoting the XIRR number.

You can invest in such an investments if you have the ability to optimally reinvest all the repayments as they hit your bank account. If you cannot reinvest so quickly—most retail investors cannot—then you are better off ignoring the quoted XIRR and calculating the investment’s CAGR instead. Or, just calculate the corpus you’ll get from this investment and compare that with the other investment you may make instead (such as PPF or bank deposit or debt mutual fund).

Holding volatile assets can be frustrating

I was planning to sell some of my Google shares (GOOG) by the end of this month. Just a few more days to go for the end of the month, but all of a sudden, GOOG has fallen by about 7% in the last 5 days.

I already had to change my plans once because Google share prices fell badly right before I was going to sell them. Now this is the second time within a year where my plans are changing because of price movements.

Not everything is bad news, however. The way price moves up is also dramatic. See how rapidly the price has risen by the end of August only to fall again just as dramatically within a few weeks. (I also sold some shares at $138 when the going was good.)

The Motley Fool says this about growth stocks:

The price of a growth stock tends to be extremely sensitive to changes in future prospects for a company’s business. When things go better than expected, growth stocks can soar in price. When they disappoint, higher-priced growth stocks can fall back to Earth just as quickly.

GOOG being a growth stock means such high volatility is to be expected.

Not too long ago, I was afraid of losing the high growth that comes through Google shares. Now I am starting to appreciate the lower volatility that diversified stock portfolios (e.g. mutual funds) offer.

Takeaways for me

• Selling mutual fund units is far easier—emotionally speaking—than selling something as volatile as GOOG is.
• The more volatile an asset is, the harder it is to use it in financial plans.

Don’t sort debt funds by recent returns

I learnt about debt mutual funds before I learnt about equity mutual funds. I consider myself more knowledgeable in debt more than in equity. What follows is one of the first lessons I learnt about debt mutual funds.

When you come across a debt fund that has given incredibly high return than its peers, it’s usually a sign that this fund has had a troublesome past. In the screenshot below, we see that Bank of India AMC’s Short Duration debt fund is topping the charts with 14% and 12% returns while other funds have given merely 7.5% or 6% return.

It takes only a few seconds to see why the high returns.

This is ICICI’s short duration debt fund. Nothing stands out here: just some volatility over the past 5 years, and it’s given 8.2% annual return.

Now look at the Bank of India fund: it has seen about 3 credit events in the past 5 years! Thankfully, the fund has recovered from 2 of these credit events, it looks like. After all that drama, this fund has managed to earn at 4.1% per annum over the past 5 years.

That was interesting to see, but what’s the takeaway? If we cannot rely on recent return data, what data can we look at then? I am no expert, but the following is what I do.

• I like to look at past portfolios and fact sheets of the fund to see how much risk they take. I don’t like anything below AAA. So many funds invest in AA bonds since they are pretty safe on typical days, but I am too conservative for that.
• I especially like funds that choose PRC matrix positions of A-I, A-II, and A-III since they commit to not holding too much sub-AAA debt. Unfortunately, many funds that never/seldom hold sub-AAA debt choose the ‘B’ position just to have some extra wiggle room.

Can we “buy the dip”?

New investors cannot earn outsized return by investing in debt funds after they have seen credit events. If someone bought Bank of India Short Duration debt fund a year ago, what return they’ll be looking at? Definitely not 14% because they wouldn’t have gotten access to the troubled bonds. They will likely be getting around 7.5% which seems to be the typical return.

Once there is a credit event, the troubled debt assets are moved to an illiquid “segregated portfolio”. New subscriptions to the scheme only get access to the “core portfolio”, i.e. the debt assets that are not troubled. Existing investors who have a share in the segregated portfolio will have to live with the troubled bonds until either the bonds become good again or go completely to zero.

You seldom win by taking credit risk. It’s prudent to exhaust your risk appetite in “safer” assets like equity rather than betting on lower quality debt.

Uncharted territory

Every territory is an uncharted territory.

Maybe a thousand people have already done what you are about to do. But that doesn’t make a difference to you if this is the first time you are doing it. When you do it, you should do it your way. That means you learn, improvise, and improve as you go.

So what are the takeaways?

• Remember that you don’t have to copy others. Do it in your own way.
• You have learnt and done so many things in life. The challenge of this new thing is not going to define you. (You do not define yourself based on how you fare in this one challenge.)