Investing in government bonds is important to diversify your investment portfolio. Government bonds are essentially loans made to a corporation or government in return for interest payments on a regular basis. When someone buys a bond or security, they are essentially providing a loan to the issuer.
In the case of government securities and bonds, the issuer is the government. These types of bonds are considered relatively safe investments because they are backed by the government. There are a few different types of government securities and bonds to choose from, and each has its own set of characteristics and risks.
What are bonds?
Bonds are a type of investment that typically offers a fixed return and serves as a source of regular income. Bonds are a popular investment option among investors who prefer to invest in low-risk instruments. Different types of bonds are available in the market, each with different features and characteristics that cater to the needs of diverse investor groups.
What are government bonds?
Government bonds are debt-based investment instruments where the government borrows money from investors in exchange for an agreed-upon interest rate. The government issues bonds to raise funds to finance various new projects and develop infrastructure. Investors, on the other hand, are paid set returns at regular intervals. When an individual invests in government bonds, they are lending money to the government in exchange for regular interest payments (coupon payments) over a specified period, and the return of the principal amount at the bond's maturity.
Key characteristics of government bonds
Here are the key characteristics of government bonds in India:
- Fixed maturity: Government bonds have a predetermined maturity date, indicating the length of time until the government repays the principal amount to the bondholder.
- Interest payments: Investors receive periodic interest payments (known as coupon payments) until the bond matures.
- Debt securities: These bonds are debt instruments issued by governments to raise funds for various purposes, such as financing infrastructure projects, covering budget deficits, or implementing social welfare programs.
How do government bonds work?
As mentioned earlier, government bonds are a type of debt security where the government borrows funds for a predetermined time frame. Government bonds operate on a relatively simple principle. The government issues these bonds to raise capital, while investors purchase them with the agreed-upon amount. The government invests these funds in various projects. In return, investors are promised regular interest on the invested sum.
Depending on the type of bond in question, this interest can be fixed or variable. The principal sum is returned to investors when the bond matures.
Bond prices in the secondary market change with interest rate fluctuations. They move in an inverse direction to the prevailing interest rates. In other words, when interest rates go up, bond prices fall, while when interest rates come down, bond prices rise. This impacts the bond yield or the total return the investor earns from his investment.
Government bonds come with varied maturity periods. In India, government bonds offered varied maturity durations ranging from 91 days to up to 40 years. You can also sell a government bond on the secondary market before its maturity date. However, if the bond’s price has fallen, you may have to sell it at a lower price than its purchase cost, losing out on a part of your principal investment.
Before you invest in government bonds, understand the following terms thoroughly:
- Maturity: The maturity period is the investment tenure of the bond starting from the day the bond is issued to the day it matures. It is the period during which the investor earns interest on his investment. The maturity date is when the principal sum invested becomes due.
- Principal: Principle refers to the lump-sum initial investment made to purchase the bond. It is also known as the face value of the bond. This is the sum the issuer promises to repay the investor upon maturity.
- Bond price: Bond price is the price at which the government issues a bond. Once issued, bond prices are subject to fluctuations due to changes in the interest rates in the secondary market.
- Coupon rate: A coupon rate is the interest rate paid by the issuer on the face value of the bond. The issuer will fix this coupon interest rate at the time the bond is issued.
- Coupon date: Coupon dates are the dates when the government must credit the interest receivable by the bondholders. Since interest is paid at regular intervals, coupon dates may be scheduled monthly, quarterly, semi-annually, or annually.
Types of government bonds in India
India offers several types of government bonds to cater to the diverse investment needs of investors. Here are the most common types of government bonds in India:
1. Fixed-rate bonds
Fixed-rate bonds are a type of government bond that comes with a fixed rate of interest that remains the same throughout the bond’s tenure. In other words, the interest rate applicable to such bonds does not fluctuate with changes in the prevailing market interest rates. Most government bonds in India are fixed-rate bonds with the coupon rate mentioned in their nomenclature.
For instance, a 7% GOI 2018 was issued by the government in 2018, offering a 7% annual rate of interest on the face value of the bond. Since fixed-rate bonds offer a consistent interest income, these bonds are best suited for investors seeking a fixed and stable income from their investments.
2. Floating-rate bonds
Floating-rate bonds, or FRBs, are the opposite of fixed-rate bonds. FRBs do not carry a fixed coupon rate. Instead, these bonds carry a variable interest rate that’s adjusted in keeping with a benchmark rate. The interest rate is revised at pre-announced intervals, like every 6 months. This means that the rate of interest on these bonds will be reset every 6 months from their date of issuance to their maturity date. Certain FRBs have a base rate and a fixed spread. The spread remains fixed throughout the tenure of the bond.
3. Sovereign gold bonds
Introduced in 2015, sovereign gold bonds are issued against grams of gold, whereby investors can invest in gold without the need to hold the asset in a physical form. SGBs are issued by the RBI on behalf of the Government of India in tranches for limited periods. The price of an SGB is linked to the price of physical gold. The nominal value of an SGB is calculated by computing the simple average closing price of 99.99% purity gold three days before the bond’s issuance. SGBs come with a minimum tenure of 8 years, but investors can encash their SGBs after the first 5 years. However, such encashment is permitted only on the interest payment date. SGBs pay an annualised interest rate of 2.5%, which is payable on a half-yearly basis. Returns are linked to the prevailing market price of gold. Investors can hold SGBs in physical paper format or a dematerialised format, and the maturity proceeds from such bonds are tax-free (if redeemed at maturity).
4. 7.75% GOI savings bonds
The Indian government introduced the 7.75% GOI Savings Bonds in 2018 to replace the 8% Savings Bonds. As evident from the name of the bond, these bonds offer a fixed coupon rate of 7.75%. The interest earned on these bonds is subject to taxation as per the investor’s applicable income tax slab. Ideal for new and risk-averse investors, these Savings Bonds offer stable returns at a fixed rate. These bonds are issued against a minimum investment of Rs. 1000 and come with a maturity tenure of 7 years. However, in 2020, the RBI issued a circular withdrawing 7.75% Savings Bonds from the market. In other words, it notified investors that there would be no fresh issues of the bond.
5. Inflation-indexed bonds
Inflation index bonds, or IIBs, are a unique type of government bond where the interest is protected against inflation. These bonds use either one of the two inflation indexes: the Consumer Price Index (CPI) or the Wholesale Price Index (WPI). IIBs function like fixed-rate bonds, with the additional perk of offering inflation-adjusted returns. In other words, the interest paid on these bonds is inflation-adjusted, making them ideal for investors seeking to protect the real value of their investment and returns. A sub-variant of IIB is the Capital Indexed Bond, where the principal sum is linked to the accepted inflation index and protected from inflationary pressures.
6. Zero coupon bonds
As evident from the name, zero coupon bonds do not have a coupon rate. In other words, they do not pay interest to investors. Instead, the returns from such bonds are tied to the difference between their issuance price and redemption value at maturity. These bonds are issued at a discount and redeemed at face value.
7. Bonds with call or put option
Bonds with call or put options have certain unique features. These bonds offer the issuer a call option to buyback the bond and the investor a put option to sell the bond to the issuer. However, this can only occur on the date of interest disbursal after the first 5 years of issuance. There are 3 subtypes under this category: bonds with only call option, bonds with only put option, and bonds with both. Both the buying and selling happen at face value.
Government bonds are a reliable and secure investment avenue for long-term investors seeking a fixed income with a steady and assured return over time. Depending on an investor's financial goals, they can choose from a broad range of government bonds that cater to their investment requirements. Moreover, as government bonds are backed by the government, they carry low default risks, making them one of the safest investment options available.
What affects the price of government bonds?
Here are the factors that affect the prices of government bonds:
Supply and demand
Just like all financial securities, government bond prices are also affected by the forces of demand and supply. The supply of government bonds is determined by the government and changes each time the government decides to issue new bonds. The demand depends on how attractive the bond is to investors. If the supply is more than the demand, bond prices drop, while if demand exceeds supply, bond prices rise.
Interest rates
Interest rates are closely linked to the prices of government bonds. If the prevailing interest rates are lower than the bond’s coupon rate, the demand for the bond will rise, resulting in a corresponding rise in their prices. However, if interest rates rise higher than the bond’s coupon rate, the demand will fall, resulting in a fall in the bond prices.
Maturity date
The maturity duration of a bond has an impact on its price. The bond’s price moves towards the par value as the maturity date nears. As the bond moves towards its maturity date, it becomes less sensitive to market volatility. Similarly, a longer term to maturity increases interest risks, making the bond more susceptible to market volatility. In short, short-term bonds (or those close to maturity) experience lower price volatility than long-term ones.
Inflation
High inflation rates are generally bad omens for bondholders in two ways. Firstly, fixed-rate coupon payments become less valuable since inflation devalues the purchasing power of funds. Secondly, most Central Banks tackle rising inflation rates with a subsequent rise in interest rates. Since interest rates and bond prices are inversely related, rise in interest rates results in a fall in the bond price.
Who should invest in government bonds?
Government bonds are one of the safest forms of fixed-income investment avenues in India. Backed by the sovereign guarantee, government bonds carry a very low risk of payment default. This makes them ideal for risk-averse investors who prefer capital preservation and wish to avoid the intense uncertainty linked to other market-linked instruments like equities.
Additionally, most government bonds come with a fixed coupon rate, offering investors consistent returns. Therefore, investors seeking predictable and stable income inflows, like retirees, can invest in government bonds. Given the low-risk quotient of these bonds, they are also apt for investors looking to dilute the risk factor in their portfolio. Government bonds offer stable returns against low risk with the benefit of capital preservation, making them complementary investments to high-risk assets.
So, if you have a high-risk equity portfolio, you can invest in low-risk fixed-income assets like government bonds to ensure diversification. Investing in government bonds, along with equities, helps you optimise the risk-to-return balance of your portfolio.
Moreover, unlike equity and Forex investments, where you need to have market knowledge, conduct fundamental analysis, and weigh risk factors to invest and earn returns, investing in government bonds is relatively simple since it does not require significant financial expertise. The Indian government makes various resources available online to help new investors educate themselves about the various types of government bonds and understand how government bonds operate. This makes them ideal for novice investors seeking to build a low-risk portfolio with stable earnings.
Pros and cons of investing in government bonds
Investing in government bonds can offer several benefits, as well as some drawbacks. Here are a few of the pros and cons of buying government securities:
Pros:
- Safety: Government bonds are some of the safest investments available. Because they are backed by the government, they are virtually risk-free.
- Regular income: Most government bonds pay regular interest payments, which can provide a steady stream of income for investors.
- Tax benefits: Some government bonds offer tax benefits to investors, such as exemption from local and state taxes.
- Liquidity: Government bonds are usually traded in large volumes, which means they are more liquid than other types of investments like stocks.
Cons:
- Low returns: Because government bonds are so safe, they typically offer lower returns than other types of investments, such as stocks or corporate bonds.
- Interest rate risk: Government bonds are sensitive to changes in interest rates. If interest rates rise, the value of existing bonds may decrease, which could result in lower returns for the investor.
- Inflation risk: If inflation rises, the purchasing power of the regular interest payments received from government bonds may decrease.
- Market volatility: Although government bonds are generally considered to be safer investments, they are not immune to market volatility. Economic factors, political events, and other factors can affect the value of government bonds.
Risks of government bonds
Government bonds are generally considered ultra-low-risk investments since they come backed by a sovereign guarantee. While these bonds are safer than other investment options, they do carry the following risks:
Inflation risk
Inflation risk is the risk of rising inflation levels devaluing your bond investment. When inflation rises, the purchasing power of money declines. Therefore, if the prevailing inflation rate is higher than the coupon rate of the bond, the real value of your investment declines. A good way to manage this risk is investing in inflation-indexed bonds that ensure inflation-adjusted returns.
Interest rate risk
Interest rate risk is the risk that the bond’s value will fall due to a rise in interest rates. As mentioned earlier, bond prices are inversely related to interest rates. If the interest rate rises, bonds will go down in value because new bonds will be issued with a higher coupon rate. This will make existing bonds with a lower coupon rate less appealing to investors.
Credit risk
Credit risk is the risk of default where the issuer cannot repay the principal and interest owed. Unlike corporate bonds, where credit risk is quite significant, government bonds generally do not carry a significant credit risk. That said, the government can still default on the bond due to different reasons like political instability, economic downturns, or high debt levels.
Currency risk
Currency risk only occurs when the bond pays out in a currency that’s different from your reference currency. Here, fluctuating exchange rates can potentially lower the value of your investment.
Liquidity risk
Liquidity risk refers to the risk of not being able to sell the bond before the maturity date. This may happen due to a lack of buyers and sellers for the bond in the market. In instances of low liquidity, you may have to sell the bond at a lower-than-desired price, resulting in losses.
Key takeaways related to investing in government bonds
Investing in government securities and bonds can be a great way to diversify your investment portfolio and provide a stable source of income. However, it is important to understand the risks and benefits associated with this type of investment. Here are a few key takeaways and insights to consider before investing in government bonds:
1. Understand the types of government bonds available
There are several types of government bonds available, each with its own set of characteristics and risks. Understanding the differences can help you make informed investment decisions.
2. Consider your investment objectives
The decision to invest in government securities should be based on your investment objectives. If your primary goal is to preserve capital and generate regular income, investing in government bonds may be a good fit.
3. Stay up to date on economic events
Economic Factors such as inflation, interest rates, and political events can all affect the value of government bonds. Keeping up to date on these events can help you make informed investment decisions.
4. Diversify your portfolio
As with any investment, it is important to diversify your portfolio to minimise risk. Investing in a variety of assets such as stocks, bonds, and real estate can help protect your portfolio against market downturns.
