Bonds are debt instruments used by governments and other public/private sector entities to raise funds for their projects. In exchange, they pay guaranteed, predictable returns to the investors. Therefore, bonds are a win-win for both fundraising entities and investors. Depending on the issuing entities, bonds can be classified into government bonds, corporate bonds, public sector bonds, and municipal bonds.
As the name suggests, government bonds are issued by the government. Similarly, corporate bonds are issued by companies, public sector bonds by public sector companies and municipal bonds by local municipalities. As they are backed by the government, government bonds are usually the most secure type of bonds to invest in. In this article, we will be discussing the meaning, types and pros and cons of investing in government bonds.
What is a Government Bond?
A government bond is issued by the government to borrow funds from the general public. When you buy a bond, you lend money to the government and, in return, you are paid periodic interest payments as per a pre-decided coupon rate. At maturity, you can redeem the principal amount, also called the “face value” of the bond. It is possible that the bond is issued at a discount to the face value.
The Reserve Bank of India issues bonds on behalf of the government of India. These are tradeable and fungible government securities or G-Secs. In common parlance, government securities with a maturity of less than one year are called treasury bills, and those with longer maturity are called government bonds.
They are practically risk-free and are called “gilts” or “gilt-edged securities.” For the purpose of this article, we will use government securities and government bonds interchangeably.
Types of Government Bonds
There are different types of bonds issued by the government with different maturities, coupon rates, and other features:
1. Dated Government Securities
These securities have a fixed or floating interest rate paid semi-annually on their face value and can be redeemed at pre-specified maturity date. Generally, the tenure of these securities is 5 to 40 years.
The nomenclature of dated government securities usually contains the coupon rate followed by the issuer followed by the maturity year. For example, “7.17% GS 2028” stands for a bond paying a coupon of 7.17%, issued by the Government of India and maturing in 2028.
There are multiple types of Dated Government Securities:
- Based on whether these securities pay fixed or floating rates of interest, they are classified into fixed rate bonds and floating rate bonds. When these securities do not pay a coupon and sell at a discount, they are called “Zero-Coupon Bonds.” For instance, the government issued a floating rate bond in 2020 with a coupon rate of 35 bps spread over the interest rate of the National Savings Certificate. The bond’s coupon rate is reset every six months based on the latest NSC interest rate.
- Some dated securities have their principal amount or interest linked to an index like the Wholesale Price Index (WPI) or Consumer Price Index (CPI). This indexing ensures that inflation doesn’t erode your invested capital or total returns. Based on whether only the principal is indexed or both principal and interest payments are indexed, dated securities are classified into capital indexed bonds and inflation index bonds.
- Some dated securities come with a built-in call or put option. Based on these, government bonds are categorised into callable and putable bonds. Callable bonds can be repurchased by the issuer at face value at some designated time before maturity. Similarly, putable bonds can be sold by the investor to the government at face value before maturity at a pre-specified time.
2. Treasury Bills
These government securities come with three different maturity periods:
- 91 days
- 182 days
- 364 days
These securities do not have any coupon payments. You can buy them at a discount to their face value. For example, a treasury bill with a face value of Rs. 100 is issued at a discounted price of, let’s say, Rs. 98.3. If you buy it, your gain at redemption would be Rs. (100 – 98.3) = Rs. 1.70.
The RBI auctions 91-day T-bills every Friday and 182-day and 364-day bills every second Wednesday.
3. Cash Management Bills
They are relatively newer instruments of investment and were launched in 2010 by the RBI for the first time in India. Their features are similar to those of T-bills, except that their maturity period is less than 91 days. They are not auctioned on a periodic basis by the RBI and are only issued to meet temporary mismatches in government cash flows.
4. State Development Loans
The bonds issued by state governments are referred to as “State Development Loans.” They are similar to Dated Government Securities as they have a fixed maturity date and pay interest at half-yearly intervals. The face value is redeemed at maturity. Their issues are also facilitated by the RBI through the Negotiated Dealing System.
Also Read: Learn How to Buy Sovereign Gold Bond
Advantages of Investing in Government Bonds
Risk-Free Investment Instrument
These bonds are guaranteed by the government of India. The possibility of a default, therefore, is practically zero. So, if you are a risk-averse investor, these bonds are perfect for you.
Inflation Adjusted Returns
Inflation index bonds have provisions to adjust the principal and the interest amount as per the movement in the inflation index to ensure real returns. Similarly, capital indexed bonds have the principal amount adjusted as per an inflation index to prevent the capital from reducing in value due to inflation. That is, the face value at redemption is increased by a factor of the increase in inflation during the duration of the bond.
Government bonds are one of the most liquid investment instruments in the country, right next to cash, demand drafts, and cheques. You can even pledge them to get loans. Financial institutions can use these bonds to fulfil their SLR (Statutory Liquidity Ratio) requirements. They can be sold quickly in the secondary market with a settlement period of t+1 (settlement complete one day after the date of transaction).
You can use government bonds to diversify the risk of your portfolio. By being risk-free, they reduce the overall risk exposure of your investment portfolio. They come with various maturity periods, from less than 91 days to 40 years. Therefore, you can ladder your investments using these.
Excellent Source of Regular Income
Government bonds that pay regular coupon payments can become a source of steady income for those who need one. People without a stable income source, such as freelancers, salespeople, etc., can invest in these bonds to ensure the stability of funds. These bonds are also an excellent tool for planning a retirement portfolio.
Disadvantages to Investing in Government Bonds
The returns that you get on government bonds are less than that on corporate bonds or equity instruments. Especially in the case of long-term bonds, when market interest rates go on increasing, the returns on government bonds eventually turn out to be very low.
Interest Rate Risk
For government bonds with long-term maturity – 5 – 40 years. In this case, there is an interest rate risk. This is because, when the interest rates increase during the tenure of the bond, it becomes more beneficial to invest in newer bonds than the current ones. As a result, the bond prices drop to match the yield of the newer bonds.
Who Should Invest in Government Bonds?
Government bonds in India are one of the safest investment instruments. If you are totally risk averse, you should definitely consider investing in government securities. Another reason why you may consider investing in government bonds is to lower the overall risk exposure of your portfolio.
Furthermore, if you are just a beginner, you can start by putting your savings in government bonds while you grasp the concepts of market-linked instruments such as stocks.
Government bonds are fixed-income investment instruments that come with a sovereign guarantee. Government bonds are practically risk-free. That being said, since the returns on government bonds are lower than equity and even other debt instruments like corporate bonds , you must consider your investment goals before investing in government securities. If you are aiming for significant passive income in the short term, investing in government bonds may not be a good idea. On the other hand, if you are a retired individual and are looking for a risk-free fixed income for the rest of your life, government bonds might be a good choice for you.
FAQs about Government bonds in India
What are bond yields?
Bond yield is the measure of the returns that you earn on a bond. They are calculated by dividing the coupon payments by the market price of the bond. When market interest rates increase, the bond yields of the newly issued bonds become more desirable. The bond prices of older bonds, therefore, fall in order to give the same bond yield as the new bonds.
What are open market operations?
Open market operations are the activities of the RBI concerning buying and selling government bonds to manage the liquidity in the market. When it feels that the liquidity in the market is very high, it sells government bonds to reduce it. On the other hand, if it feels that the market is in need of some liquidity, it buys back bonds.
How and in what form can G-secs be held?
G-Secs can be held in both dematerialized form and physical form. The physical bonds are in the form of stock certificates. You need to open a Demat account with a securities broker in order to hold bonds in Demat form.
How to buy government bonds in India?
Institutional investors buy government bonds through a process of competitive bidding. As retail investors, you can buy government bonds by non-competitive bidding directly from exchanges through the application – NSE goBID. You have to register for this app and link your account to your Demat account.
You can also buy government bonds on the RBI Retail Direct platform.
What are capital gain bonds?
Also called 54EC bonds, these are the bonds used to obtain a tax exemption on capital gains from the sale of immovable property. If you invest the profit earned from selling your property in these bonds within six months of the sale, you will be exempt from paying capital gains tax on this profit. Note that only an investment of up to Rs. 50 lakhs in capital gains bonds are exempt from taxation. Bonds issued by Rural Electrification Corporation (REC), National Highway Authority of India(NHAI), Power Finance Corporation Limited(PFC) or Indian Railway Finance Corporation Limited(IRFC) are capital gain bonds.
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.