What is a Government Bond?
Government bonds are debt instruments issued by India’s State and Central Governments. Such bonds are issued when the issuing body encounters a liquidity problem and needs funds for infrastructure development. The bonds issued by the State Governments are called SDLs or State Development Loans. On behalf of the Government of India, the bonds are issued by the RBI to finance the fiscal deficit.
In India, government bonds are typically a contract between the bond issuer and investor. Here, the issuer guarantees interest earnings on the bond’s face value held by investors and principal value repayment on an agreed period.
Government bonds in India are categorized under government securities (G-sec) and are long-term investment tools issued for five to forty years. Primarily, all G-secs were issued for the benefit of large investors, such as commercial banks and companies. But eventually, GOI made them available to smaller investors, such as co-operative banks, individual investors, etc.
Since the issuing governments back these bonds, they are considered low-risk investments. The government bond interest rates can either be disbursed or float on a semi-annual basis.
How Do Government Bonds Work?
Investors who purchase government bonds lend the government an agreed amount for a stipulated period. The government, in return, will pay you back a specified level of interest at fixed intervals, known as coupon. This is what makes government bonds a fixed-income asset.
The original investment amount (principal) is returned to the investors when the bond expires.
Once the bond expires, your original investment amount – called the principal – will be returned to you. The day on which you receive the principal is called the maturity date. Different bonds will come with different maturity dates – you could buy a bond that matures in less than a year or 30 years or more.
Types of Government Bonds in India
India has different government bond types, which might vary depending on the coupon rates, issuer, and tenure. According to the bond issued, it might come with varying risks and interest rates. By considering these essential factors, investors can make their choice. If you’re not familiar with the types of government bonds India, continue reading.
1. Fixed Rate Bonds
For fixed rate bonds, the interest rates are fixed. Irrespective of the market rate fluctuations, it remains consistent across the investment tenure. These are great options for investors seeking guaranteed interest rates for a stipulated period.
2. Sovereign Gold Bonds (SGB)
Sovereign Gold Bonds or SGBs are bonds issued by the Central Government. Tax exemption is provided on the interest earned from these bonds. Investors can invest in gold for a long period without investing in physical gold.
Investors who prefer low-risk investments can consider SGBs. The expenses incurred in purchasing or selling SGBs are low compared to the physical gold. It is a good investment option.
3. Floating Rate Bonds (FRBs)
Floating Rate Bonds or FRBs are subject to periodic changes in their interest rates. The change is undertaken at intervals and is declared beforehand when the bond is issued. For example, an FRB might have a pre-announced interval of six months. The interest rate will change every six months throughout the bond tenure.
4. Inflation Indexed Bonds
The principal amount and the interest earned by investing in inflation indexed bonds correspond to deflation or inflation. Also known as inflation-linked bonds, they are specifically issued to retail buyers. The bond is available for trade in the secondary market.
These bonds are indexed according to the WPI (Wholesale Price Index) or CPI (Consumer Price Index). Such IIBs make sure real returns accrued remain constant. Therefore, investors can safeguard their portfolios against inflation rates.
5. 7.75% GOI Savings Bond
According to the RBI directive, 7.75% GOI Savings Bond can be held by an undivided Hindu family, an individual or individuals who are not NRI, and a minor with legal guardian representation.
These bonds are issued at a minimum of Rs. 1,000. The interest earned from these bonds is taxable per the Income Tax Act 1961. It comes under the purview of the investor’s income tax slab.
6. Bonds with Call or Put Option
In this type of bond, issuers exercise the right to buy back bonds (called the call option) or the right to sell (called the put option) to the issuer. The investor or the issuer buying Bonds with Call or Put Option are in a position to exercise the right to sell or buy back these bonds after five years from their date of issuance.
In any case, the bonds can be bought back by the government at face value. Similarly, the bonds can be sold by investors to the issuers at face value. Therefore, the corpus invested is preserved in case of any downturn in the stock market.
7. Zero Coupon Bonds
Zero Coupon Bonds don’t earn any interest. The income generated from these bonds accrues from the difference in the issuance price at the discount and redemption value at par. These bonds are not issued through auction. They are created from existing securities.
Features of Government Bonds
- Low-risk investment because the bonds are backed by the security of the issuance, i.e., the government of India.
- The bonds can only be issued by the State, Central, and Semi-government authorities.
- These bonds can carry either a floating interest rate or a fixed interest rate.
- The returns are comparatively lower than other investment options.
- Investors can purchase government bonds through RBI’s Retail Direct, accessing the primary and secondary government securities market, and signing up on the Yubi platform.
- These bonds can be issued as a collateral loan against borrowing on a short-term basis. Government bonds can be exchanged for cash and the bond’s repurchase agreement in the future at a specific date at the end of the contract.
- Typically, government securities are issued in denominations of Rs. 100. They can also be issued at a discount but never a premium.
- Government bonds offer certain tax exemptions.
Factors Affecting the Price of Government Bonds in India
The different factors affecting the price of government bonds are mentioned below.
Demand and supply
Government bond prices are dictated by supply and demand. The supply of these bonds is set by each government, who will issue new bonds when required. The demand for government bonds depends on whether the bond looks like a lucrative investment.
Rate of interest
The rate of interest can have a significant impact on the demand for bonds. If the interest rates are lower than the coupon rate, the demand for that bond will likely rise because it represents an attractive investment. However, if the interest rate rises above the coupon rate, the demand will potentially drop.
The bond maturity date
Newly issued government bonds are priced according to the current interest rates. It means that they are typically traded at or near their par value. So, when a government bond has reached maturity, it is just paying out the original loan. The bonds move back to their par values as they reach maturity.
The remaining interest rate payments also influence the bond price before the bond matures.
Government bonds are considered low-risk investments since the possibility of a government defaulting on its loan payment is low. However, defaults can still happen, and a riskier bond will trade at a lower price than a bond with a lower risk and a similar interest rate.
Investors can assess the risk of a government defaulting by studying its credit ratings.
For bondholders, a high inflation rate is a bad news. The reasons for this are as follows.
- When the purchasing power of the coupon declines due to inflation, the fixed coupon payment becomes less valuable to investors.
- Central monetary authorities like the RBI typically increase interest rates when high inflation sets in. The bond prices and interest rates are inversely related. Therefore, the highest interest rates result in a lower market price for the bond.
Advantages of Investing in Government Bonds?
Premium status is enjoyed by Government Bonds concerning the promise of assured returns and fund stability. Since G-Secs are a formal declaration of the government’s debt obligation, it refers to the issuing governmental body’s liability to repay the money according to the stipulated terms.
The balances held in Inflation-indexed Bonds are adjusted against the increasing average price level. Besides this, the principal amount invested in Capital indexed bonds is also adjusted against inflation. Investing in such bonds enhances the value of the deposited funds. Thanks to this feature, investors are less susceptible to becoming financially undermined.
Regular source of income
According to RBI regulations, the earned interest accrued on Government Bonds is meant to be disbursed every 6 months to debt holders. It allows investors to earn regular income by investing their idle funds.
Why Invest in Government Bonds?
Government Bonds are good investment options because they carry lower risk when compared to other assets like equities. Furthermore, the returns are guaranteed by the government. While there are some market-related risks, investors can nullify the risks by holding on to government bonds until maturity.
Investors get a fixed interest rate on government bonds, and you can derive maximum yield by investing in these bonds until maturity. You can also consider investing in government bonds to diversify your portfolio because they are largely stable and perform exceptionally well when other asset clauses perform under pressure.
Government bonds are one of the safest investment options because they are backed by the credit and full faith of the Government of India. These are low-risk investments and can help diversify your portfolio. Therefore, government bonds are a good investment.
A demat account is necessary for purchasing government bonds in India. Your demat account will hold all the bonds in an electronic form. You can register yourself on the stock exchange for non-competitive bids.
To purchase government bonds, investors must provide relevant and necessary documents like PAN card, address proof, Aadhaar card, ID card, demat account number, etc.
If you are a retail investor, you must submit an application form and the necessary documents. Once the application is processed, the authorities will conduct a thorough background check and verify the documents submitted by you. After the successful verification, investors will receive a bond certificate.
Alternatively, you can register yourself on the Yubi platform and get access to all the different types of government bonds. You can compare all the options on this platform and directly buy and sell bonds.
Government bonds provide a steady and regular source of income. So, according to the RBI mandate, you will receive interest earnings on these bonds every 6 months.
Furthermore, these bonds will allow you to diversify your investment portfolio. You can use these bonds to hedge against market lows because the guarantee of the Central Government backs the returns.
These bonds involve very little risk, and you are assured of receiving the principal amount upon maturity of these bonds.
Additionally, interest earned from certain government bonds is not liable for income tax. So, certain bonds are tax-free, and you don’t have to worry about paying taxes on the amount earned.
In some cases, interest earnings from government bonds are taxable on the income tax slab rate. However, certain bonds are tax-free, and the bonds enjoying this status are issued by public sector enterprises like REC (Rural Electrification Corporation), HUDCO (Housing Development Corporation), etc.
The interest rate keeps fluctuating as per the value of the government’s borrowing program and the monetary policy of the RBI. Investors are presented with a yield of 6.126% on government bonds in investment for ten years. So, if you hold a government bond for ten years, you will get a return of 6.126% annually.
Furthermore, investors can invest in treasury bills with a maturity period of 365 days or less. Due to their short tenure, they offer a lower interest rate.