Government Bonds

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What are Government Bonds

Government Bonds, also known as Dated Securities, are long-term debt instruments with an original maturity of one year or more. The central and state governments use government bonds to raise funds to support their spending and obligations. Bonds issued by the state governments are known as State Development Loans (SDLs). Government bonds are usually issued with tenures of 5 to 40 years.

Types of Government Bonds

Fixed Rate Bond has a fixed coupon rate (interest rate), i.e., it remains the same till its maturity. Most government bonds in India are issued as fixed rate bonds.

Floating Rate Bond does not have a fixed coupon rate. Instead, their coupon rates are resets at pre-announced intervals, for instance, half-yearly or annually. There are two main ways in which the coupon rate is decided:

• The coupon rate can be the average rate (rounded off up to two decimal places) of the implicit yields at the cut-off prices of the last three auctions held before the rate setting date.
• The FRB can also carry a coupon rate, which has a base rate and a spread. The spread is decided at the time of bond issuance and remains the same for the entire duration of the bond. The base rate, on the other hand, is equivalent to the Weighted Average Yield of the last three auctions from the rate fixing day.

Zero Coupon Bonds do not offer any coupon payments. Instead, they are issued at a discount and redeemed at face value. The Government of India last issued these bonds in 1996.

Capital Indexed Bonds have their principal amount linked to a pre-determined inflation index with the aim to protect the investor’s principal amount from the impact of inflation.

Inflation Indexed Bond (IIB) were also introduced to protect the government bondholders from inflation. However, in case of IIBs, both the interest flows and the principal amount is linked to a pre-set inflation index. The index used for this purpose can be either the Wholesale Price Index (WPI) or the Consumer Price Index (CPI).

Bonds with Call/Put Options provide flexibility for early redemption either by the issuer or investor. Bonds with ‘call option’ gives the issuer (i.e., the Government) the right to buy back the bond before their maturity dates. On the other hand, bonds with a ‘put option’ gives their investors the right to sell their bonds back to the issuer before their maturity dates.

Governments can issue bonds having either of the pull or call option. Some government bonds may have both put and call options.

Special Securities are long-term bonds that the Government of India issues from time-to-time to entities such as Oil Marketing Companies (as oil bonds), Fertilizer Companies (as fertiliser bonds) and the Food Corporation of India (as food bonds). The government issues special securities to these entities as a means of compensating them in lieu of cash subsidies.

These securities usually offer a higher coupon rate than the yield of the government bonds of similar maturities. The entities that receive these securities can sell them in the secondary market to banks, insurance companies or primary dealers, etc. for raising funds.

Sovereign Gold Bond (SGB) has its value directly linked to the price of gold, thereby, allowing investors to invest in gold without buying physical gold. These bonds are denominated in grams of gold, with a minimum investment of 1 gram. The maximum purchase limit for a financial year is 4 kg for individuals and Hindu Undivided Families (HUFs) and 20 kg for trusts and similar entities.

SGBs have a maturity period of 8 years but investors can opt for premature redemption after 5 years, which is allowed only on the next interest payment date. SGBs offer a fixed interest rate of 2.5% p.a. on the nominal value, paid semi-annually, with the final interest paid along with the principal at maturity. The redemption price is also based on the average closing price of 999 purity gold over the last three business days before the maturity date, as published by India Bullion and Jewelers Association Limited (IBJA).

7.75% Savings (Taxable) Bonds, 2018 can be held by Resident Indians and Hindu Undivided Families (HUFs). Resident Indians can invest in these bonds individually or with another individual, on a ‘either or survivor’ basis, or on behalf of a minor as a parent or legal guardian.

There is no maximum investment limit for these bonds. They are issued at par for a minimum investment of Rs 1,000 (face value) and in multiples thereof. The interest rate is 7.75% p.a. and the interest earned is taxable according to the investor’s applicable tax status. However, these bonds are exempt from wealth tax.

State Development Loans (SDLs) are government bonds issued by the State Governments. The coupon payments for SDL are made every six months and the principal amount is repaid at maturity.

In terms of safety of capital, SDLs are similar to G-Secs. SDLs have quasi-sovereign status as the RBI directly monitors interest and maturity payments of these bonds and also has the power to make the pay-outs for these bonds from the budgetary allocation of the Central government for the bond issuing state government.

What is Government Bond Yield?

Government bond yield refers to the return that an investor earns or expects to earn from his/her investment in government bonds. Interest payments and the capital gains/losses (if there are any) earned on the sale of a bond or at maturity are considered when calculating government bond yields.

Government bond yields are often used as a benchmark for setting interest rates for corporate bonds,loans, fixed deposits and other fixed income instruments of the same maturity profile. In India, the 10-year government bond yield serves as a benchmark or reference rate for the entire bond market and often serves as a key indicator of inflation rate and interest rate expectations.

How Government Bonds Work

When investors buy government bonds, they become lenders to the government. In return, they receive regular half-yearly interest payments, and at maturity, the government repays the bond’s full face value.

Below are a few key terms related to government bonds that every investor should know about:

• Face value: A government bond’s face value, also known as par value or nominal value, refers to how much a bond will be worth on its maturity date. It is the value that the bondholder will receive on their bonds’ maturity date.
• Coupon rate: The coupon rate of a government bond in simple terms refers to government bond interest rate i.e., the interest rate a government promises to pay on the bond’s face value.
• Coupon dates: The coupon date is the date on which a government promises to make coupon payments to its bondholders.
• Maturity date: The maturity date of a government bond is the date on which a government promises to repay the face value of a bond to its investors.
• Issue price: Issue price of a government bond is the amount at which a government sells its bond to investors in the primary markets at the time of the bond issue.
• Sovereign guarantee: Government bonds are backed by sovereign guarantee, which is the highest form of capital safety that any investor can get on his/her investment.

Why Should You Invest in Government Bonds?

Investing in government bonds offers several clear advantages:

• Safety and Sovereign Guarantee: Government bonds offer maximum possible safety of capital and certainty of returns to the investors as the repayment of principal and interest components are guaranteed by the Government of India.
• Ease of Holding: Government bonds can be held in dematerialized (electronic) or physical form, reducing risks related to loss, theft or damage.
• Wider Variety of Maturities: The tenure of government bonds can range from 5 years to 40 years. This provides investors a wider choice to lock in attractive yields as per their investment horizon. Investors having shorter investment horizons can also purchase government bonds having shorter maturities from the secondary market.
• Liquidity: Government bonds can be traded in the secondary market. Investors can exit the market without incurring any prepayment penalty. However, the sale proceeds will depend on the prevalent market price of the bond.
• Attractive Yields: State Development Loans (SDLs) often offer higher yields to attract investors.
• Minimal Market Risk If Held Till Maturity Date: Government bonds are subject to price fluctuations due to changes in the interest rates, inflation rates, liquidity in the market, fiscal deficit, foreign exchange movements and other macro-economic factors. However, if held until maturity date, these risks can be eliminated. Upon maturity, investors receive the full-face value, regardless of interim market movements.

How to Invest in Government Bonds in India?

• Retail investors can invest in government bonds through auctions conducted by the RBI. The minimum investment amount required to invest in government bonds is Rs 10,000. The RBI allocates a separate quota for retail investors in each bond auction to encourage retail investment.
• Investors can invest directly in G-Sec by opening gilt accounts with banks and RBI. They can use their existing demat accounts for holding government bonds.
• Other options that retail investors can use for investing in government bonds include RBI Retail Direct, NSE goBID (Government Bond Investment Destination), BSE Direct, stock brokers and bond-purchasing platforms.

Characteristics of Government Bonds

• Highest form of capital safety: Government bonds offer maximum safety to investors as these are backed by sovereign guarantee for the on time payment of interest and principal.
• Wide range of maturities: The tenure of government bonds can range from 5 to 40 years.
• Periodic payments: Investors receive interest payments on a half-yearly basis till the bond reaches its maturity date.
• Liquidity: Investors can buy/sell government bonds in the secondary market through Negotiated Dealing System-Order Matching (NDS-OM) (anonymous online trading), over the Counter (OTC) and reported on NDS-OM, NDS-OM-Web, stock exchanges, RBI Retail Direct as well through various online bond platform providers and their partner financial marketplaces.
• Ease of holding: Government bonds can be held in both physical and demat form.

Risks of Investing in Government Bonds

Government bonds are considered risk-free investments as their chances of defaulting are negligible. However, as with other bond types, government bonds also carry other risks. A few of these risks are mentioned below:

• Market risk – It refers to the possibility that an investor will sell their government bonds at prices lower than their purchase prices. Such scenarios can rise due to various macro-economic factors affecting government bond prices. Investors can eliminate this risk by staying invested in their government bonds till their maturity risk.
• Reinvestment risk – It refers to the possibility of an investor unable to reinvest the interest payments or the face value received on the bond’s maturity date at higher or same yield.
• Liquidity risk – It refers to the possibility of an investor unable to sell his or her government bond holdings in the secondary market due to the non-availability of buyers for the security.
• Inflation risk — It refers to the risk that the rate of return earned on a bond investment will be lower than the future rate of inflation.

Government Bonds vs Corporate Bonds

for detailed comparison, check Government bonds vs Corporate Bonds

What Affects the Price of Government Bonds

Like other market-linked instruments, the prices of government bonds too fluctuate in the secondary market. The following factors may affect the prices of government bonds in India:

• demand and supply of the government securities
• the level and changes in the interest rates of the economy
• macro-economic factors such as expected rate of inflation, liquidity in the market, etc.
• developments in money markets, foreign exchange markets, commodity markets, capital markets, etc.
• developments in international bond markets, especially in the US Treasury market
• RBI policy actions like, changes in Cash Reserve Ratio, Open Market Operations, policy interest rates like Repo Rate, etc.

Taxation on Government Bonds

The taxation on government bonds involves two components — interest income and capital gains.

Taxation on the Interest Income of Government Bonds

The interest income earned from a government bond is added to the bondholder’s total income and is taxed as per his/her tax slab. To prevent TDS (tax deducted at source) on the interest income of a government bond, the bondholder can submit 15G/15H forms, which basically confirm that there is no tax liability.

Taxation on the Capital Gains of Government Bonds

The taxation on capital gains depends on how long you have held the government bonds. Short-Term Capital Gains (STCG) (gains on assets held for a period of up to 12 months) are taxed according to the tax slab rate of an investor; and the long-term capital gains (LTCG) (gains on assets held for a period more than 12 months) are taxed at 12.5% (in case of listed bonds and if the indexation benefit has not been availed) and 20% (in case of unlisted bonds).