Investing in Bonds
16/05/2020There are two reasons for it: (a) Government bonds are issued by the central government in India, (b) These bonds are regulated and managed by Reserve Bank of India (RBI).
What makes government bonds risk free is the security of the principal amount, and the certainty of the promised return. A person who wants to invest for long term, but wants to keep it risk-free, Government bonds are the best option.
Government Bonds
What are bonds and T-bills? These are Securities (G-secs) issued by the government of India to borrow money from investors. Who are investors?
- Big Investors: Banks, insurance companies, mutual funds, trusts, corporates etc. These are called big because their size of investment (in G-Secs) are large compared to small investors. Know more about mutual funds.
- Small Investors: HNI’s, NRIs, HUF members, individuals etc. In this group of people, ‘individual investors’ are the ones where we common men are placed. Read more about Peter Lynch a big HNI investor.
Government borrows money from these investors by offering them G-secs through “auctions“. How the auction is done? Through “competitive bidding” process. We will read more about it below.
In good old days, G-sec market was dominated by big players like banks, insurance companies, mutual funds etc. Small investors stood away from investing directly in bonds. Why?
- First because of the difficult process of investing in bonds. A common man just did not knew how to buy government bonds. The ease with which they can buy stocks, mutual funds etc, Government bonds purchase was not as simple. Read more about how to buy stock online.
- Secondly, because the big players used to deal in much larger volumes, individuals just could not compete with them in the “auction” process. Know if small investors shall invest in debt funds.
Government Bonds – Process of Purchase
Before Nov’2017, Government Securities (G-Secs) like bonds and T-bills were virtually non-accessible for common men (small investors). But then RBI started the “Non-competitive Bidding Facility“. This made G-secs more accessible for common men.
Lets understand more about competitive and non-competitive bidding process:
- Competitive bidding: Example: Government issues a bond of Face Value of Rs.1,000, offering an interest @8.0% p.a. In the competitive bidding process (auction), “investors” will quote a price higher than the face value (Rs.1,000). Suppose based on all bids, RBI accepts a cut-off price as Rs.1,060. In this case everyone who has quoted Rs.1,060 or more will get their quoted lot of the bond. [Note: In this case, their yield will be lower than 8.0%. How much lower? 7.54% (=8.0% / 1,060 * 1000)].
- Non-competitive bidding: RBI’s “non-competitive bidding facility” for retail investors like me and you. Small investors just need to access the mobile and web app of NSE.
mall investors like me and you can buy government bonds in India using a mobile app or a web based app of National Stock Exchange (NSE). This app is called “NSE goBID“. Either of these two apps can be used to buy the following:
- Long-dated government bonds: holding time: 5 to 40 year.
- Treasury bills (T-bills): holding time less than 1 year.
Before one can go ahead and buy the government bonds using NSE goBID, the “process of registration” must be completed. But do not worry, everything is online.
To get a better perspective of how/why a common man can invest in bonds, let’s understand why rich and wealthy like bonds.
Why wealthy prefer bonds?
The way high net worth investors think investment is slightly different than majority. They invest money in a backdrop of a condition where they have excess of it (money). How does it make a difference?
As they have money in excess, they can afford to buy bonds and not need it easily for next 10-15 years. This money can stay invested for prolonged period of time, and yield low returns (like 8% p.a.). Wealthy people do not mind it. They invest money mostly for wealth protection.
In the process of wealth protection, if their investment can yield even 8% p.a. odd returns, it is like icing on the cake. Moreover, the returns of the government bonds are almost guaranteed. How? Because they are backed by the Indian government.
Whereas when we (common men) invest money for time horizons like 10-15 years, we think about growth. For such prolonged horizons we will instead invest in equity. Why? Because our objective is wealth creation. Read more about where to invest money for high returns.
So what does this tell us about bonds? It is only for rich and wealthy, right? But there are conditions where bonds may become good investment option for common men as well. Let’s see how…
When bonds are useful for common men…
Generally speaking, when common men invest money, they do it for wealth creation. Hence, they often invest with a long term perspective (5+ years). Equity based investment options can give much higher returns than bonds.
In India, a government bond will yield returns between 7-8% per annum even in long term. But a good equity based plan can easily give 14% p.a. in a time horizon of 5+ years. Read more about types of mutual funds and their potential returns.
Types of Government Bonds in India
The multiple variants of Government bonds are discussed below:
- Fixed-rate bonds
Government bonds of this nature come with a fixed rate of interest which remains constant throughout the tenure of investment irrespective of fluctuating market rates.
The coupon on a Government Bond is mentioned in nomenclature. For instance, 7% GOI 2021 means the following
| Rate of interest on face value | 7% |
| Issuer | Government of India |
| Maturity year | 2021 |
- Floating Rate Bonds (FRBs)
As the name suggests, FRBs are subject to periodic changes in rate of returns. The change in rates is undertaken at intervals which are declared beforehand during the issuance of such bonds. For instance, an FRB could have a pre-announced interval of 6 months; which means interest rates on it would be re-set every six months throughout the tenure.
There is another variant to FRBs, wherein the rate of interest rate is bifurcated into two components: a base rate and a fixed spread. This spread is decided through auction and remains constant throughout the maturity tenure.
- Sovereign Gold Bonds (SGBs)
The Central Government issues sovereign Gold Bonds, wherein entities can invest in gold for an extended period through such bonds, without the burden of investing in physical gold. The interest earned on such bonds is exempted from tax.
Prices of such bonds are linked with gold’s prices. The nominal value of SGBs is reached by calculating the simple average of closing prices of 99.99% purity gold, three days preceding such bonds’ issuance. SGBs are also denominated in terms of one gram of gold.
As per RBI regulations, there are individual ceilings concerning SGB possession for different entities. Individuals and Hindu Undivided Families can only hold up to 4 kg of Sovereign Gold Bonds in a financial year. Trusts and other relevant entities can hold up to 20 kg if SGBs during a similar time frame. Interest at 2.50% is disbursed periodically on such SGBs and has a fixed maturity period of 8 years unless stated otherwise. Also, no tax is levied on interest earnings through such SGBs.
Investors seeking liquidity from such bonds shall need to wait for the first five years to redeem it. However, redemption shall only take effect on the date of subsequent interest disbursal.
Assuming that Mr A invested in an SGB on 1st April 2014, and interest disbursals are set on 1st May 2014 and every six months from thereon. In case he decides to withdraw it on 1st June 2019, he shall need to wait till 1st November 2019(interest disbursal date) to receive the redemption amount.
- Inflation-Indexed Bonds
It is a unique financial instrument, wherein the principal, as well as the interest earned on such bond, is accorded with inflation. Mainly issued for retail investors, these bonds are indexed as per the Consumer Price Index (CPI) or Wholesale Price Index (WPI). Such IIBs ensure real returns accrued with such investments remain constant, thereby allowing investors to safeguard their portfolio against inflation rates.
Another variant of such inflation-adjusted securities is Capital Indexed Bond. However, unlike IIBs, only the capital or principal proportion of balance is accorded with an inflation index.
- 7.75% GOI Savings Bond
This G-Sec was introduced as a replacement to the 8% Savings Bond in 2018. As noted from its nomenclature, the interest rate of such bonds is set at 7.75%. As per RBI regulations, these bonds can only be held by:
- An individual or individuals who are/are not NRI(s) in any capacity
- A minor with a legal guardian representative
- A Hindu Undivided Family
Interest earnings from such bonds are taxable under the Income Tax Act 1961 as per the investors’ applicable income tax slab. The minimum amount at which these bonds are issued is Rs. 1000 and in multiples of Rs. 1000 thereof.
- Bonds with Call or Put Option
The distinguishing feature of this type of bonds is the issuer enjoys the right to buy-back such bonds (call option) or the investor can exercise its right to sell (put option) them to such issuer. This transaction shall only take place on a date of interest disbursal.
Participating entities, i.e. the government and investor can only exercise their rights after the lapse of 5 years from its issuance date. This type of bonds might come with either:
- Call option only
- Put option only
- Both
In any case, the government can buy back its bonds at face value. Similarly, investors can sell such bonds to the issuer at face value. This ensures the preservation of the corpus invested in case of any downturn of the stock market.
- Zero-Coupon Bonds
As the name suggests, Zero-Coupon Bonds do not earn any interest. Earnings from Zero-Coupon Bonds arise from the difference in issuance price (at a discount) and redemption value (at par). This type of bonds are not issued through auction but rather created from existing securities.
Advantages of Investing in Government Bonds
- Sovereign Guarantee
Government Bonds enjoy a premium status with respect to the stability of funds and promise of assured returns. As G-Secs are a form of a formal declaration of Government’s debt obligation, it implies the issuing governmental body’s liability to repay as per the stipulated terms.
- Inflation-adjusted
Balances held in Inflation-Indexed Bonds are adjusted against increasing average price level. Other than that, the principal amount invested in Capital Indexed Bonds is also adjusted against inflation. This feature provides an edge to investors as they are less susceptible to be financially undermined as investing in such funds increase the real value of the deposited funds.
- Regular source of income
As per RBI regulations, interest earnings accrued on Government Bonds are supposed to be disbursed every six months to such debt holders. It provides investors with an opportunity to earn regular income by investing their idle funds.
Disadvantages of Investing in Government Bonds
- Low Income
Other than 7.75% GOI Savings Bond, interest earnings on other types of bonds are relatively lower.
- Loss of relevancy
As Government Bonds are long-term investment options with maturity tenure ranging from 5 – 40 years, it can lose relevancy over time. It means such bonds value loses relevance in the face of inflation, barring IIBs and Capital Indexed Bonds.