Bonds are financial products in which an investor lends money to a third party. The entity borrows money at a fixed interest rate for a set period. This entity could be the government, a bank, or a corporation. As a result, when the government issues bonds, they are referred to as government bonds.
This article has gone through government bonds in depth, including their several varieties, benefits, and drawbacks.
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What exactly are government bonds?
Advantages of investing in Government Bonds
Disadvantages of investing in Government Bonds
What exactly are government bonds?
A government bond is a debt instrument issued by the country’s central and state governments to pay their needs while also regulating the money supply. When the government needs funding for infrastructure development or to finance government spending, such bonds are frequently the solution. As a result, the government will issue bonds to the general population, encouraging investment. At the bond’s maturity date, the government will repay the principal and interest by the terms of the bond. The Reserve Bank of India supervises the issuance of government bonds (RBI).
The RBI issues bonds on behalf of the government of India to finance the fiscal deficit. Over the past few years, the bonds were issued to large market participants like companies, commercial banks and financial institutions. However, in recent years, government bonds have been available to smaller investors like individual investors, co-operative banks etc. Also, individual investors are taking a lot of interest in investing in it
These bonds in India are generally long-term investment vehicles. These bonds are for a long period, ranging from 5 to 40 years. Furthermore, government bonds are classified as government securities (G-secs). Government bonds can be issued by both the federal and state governments. State Development Loans, on the other hand, are bonds issued by state governments (SDLs).
The Government of India (GOI) issues many types of bonds. Furthermore, these bonds respond to the investor’s different needs. The coupon rate is the interest rate offered on a government bond. The coupon might be fixed or floating and is paid out semi-annually. GOI often issues bonds with fixed coupon rates in the market.
Types of Government Bonds
The many forms of government bonds are as follows.
1. Treasury Bills
T-bills, or Treasury bills, are short-term government bonds. T-bills are issued with a one-year maturity date. The Government issues these bonds in three categories: 91 days, 182 days, and 364 days. Investors do not receive coupon payments. The difference between the face value and the discounted value, on the other hand, is the profit for the investors.
2. Cash Management Bills
These bonds are very flexible short-term securities. Government issues these when it needs funding. Hence, the bond’s tenure is mainly dependent on temporary cash needs. Usually, they must be less than 91 days. It is very similar to treasury bills.
3. Dated Government Securities
This type of bond comes with varying rates of interest. The investors will benefit from the interest paid on these bonds. Dated Government securities are termed “dated” owing to the element of the predetermined maturity date. The Reserve Bank of India auctions these bonds. The following are types of dated government securities.
4. Fixed-Rate Bonds
This type of government bond has a set coupon rate for the duration of the bond. In other words, regardless of market rates, the interest rate remains fixed for the duration of the investment.
5. Floating Rate Bonds
As the name implies, the interest rate on these bonds fluctuates throughout the transaction. Interest rates are changed at predetermined intervals before the bond is issued.
A floating rate bond (FRB), for example, has a pre-announced interval of 6 months. It means that the interest rate will be reset every six months throughout the duration of the loan.
6. Zero Coupon Bonds
Zero coupon bonds, as the name implies, have no coupon payments. Profits from these bonds are generated by the difference in the issue price. As the name suggests, Zero coupon bonds have no coupon payments. The profits from these bonds arise from the difference in the issue price and redemption value. In other words, these bonds are issued at a discount and redeemed at par. Further, these bonds are not issued through auction but created through existing securities.
7. Capital Index Bonds
The principal amount of capital index bonds is tied to an accepted inflation index. This bond is issued to protect investors’ principal from inflation.
8. Inflation Indexed Bonds
The principle amount and interest payment on Inflation Index Bonds (IIBs) are linked to an inflation index. The Consumer Price Index (CPI) or the Wholesale Price Index (WPI) may be used to calculate inflation (WPI). Investing in such bonds ensures consistent real returns. It can also protect an investor’s portfolio from inflation.
9. Bonds with a Put or Call Option
These bonds include a call option in which the issuer has the right to purchase back the bond, or the investor has the right to sell bonds to the issuer (put option). Only five years after the date of issue can the investor or issuer exercise the rights.
10. Special Securities
The Government of India occasionally provides special securities to institutions such as oil marketing corporations, fertiliser businesses, the Food Corporation of India, and so on. Instead of monetary subsidies, the government issues these securities as compensation to these enterprises.
11. STRIPS
Separate Trading of Registered Interest and Principal of Securities (STRIPS) Each cash flow from a fixed-rate bond gets transformed into an individual security here. They are then traded in the secondary market. These bonds are also quite similar to zero-coupon bonds. They are, nevertheless, generated from existing securities.
12. Sovereign Gold Bonds (SGBs)
The pricing of sovereign gold bonds are tied to the price of gold (commodity price). The bond’s nominal value is based on the preceding week’s simple average closing price of 99.99% purity gold. The price list is published by the India Bullion and Jewellers Association Ltd (IBJA). These bonds are denominated in terms of one gramme of gold.
The Central Government issues SGBs, which allow investors to purchase gold without having to invest in physical gold. Furthermore, the interest on these bonds is exempt from personal taxation. Furthermore, investors seeking liquidity from these bonds will have to wait five years to redeem them.
13. 7.75% GOI Savings Bond
The GOI savings bond, which replaced the 8% Savings bond, was introduced in 2018. The interest rate on this bond is 7.75%, as stated in the nomenclature. These bonds can be held by – according to RBI regulations.
- A person or persons who are not NRIs
- A minor who is represented by a legal guardian
- An Undivided Hindu Family
The interest earned on these bonds is taxable under the Income Tax Act of 1961 at the investor’s marginal tax rate. The minimum investment amount is INR 1000 and multiples thereof.
One can also utilise Scripbox’s income tax calculator to prepare their tax returns.
14. State Development Loans (SDLs)
To address its budgetary needs, the State Government issues bonds. As a result, they are referred to as State Development Loans (SDLs). Through a negotiated dealing mechanism, the RBI enables the issue of these bonds. The government usually issues security every two weeks. SDLs also have a greater interest rate than Dated Government Bonds. However, the bond’s interest rate is only known during the auction.
Advantages of investing in Government Bonds
The following are the advantages of investing in it:
Risk-Free
Government bonds offer investors guaranteed yields and fund stability. They have always set the standard for risk-free security. Government bonds are thus suited for investors seeking a risk-free investment.
Returns
The returns on these bonds are often comparable to those on bank savings. There is also a guarantee of principal as well as set interest. These bonds, unlike bank deposits, are available for a longer period of time.
Liquidity
Government bonds can be bought and sold much like stocks. These bonds have the same liquidity as banks and financial entities.
Portfolio Diversification
An investment in these bonds provides the investor with a well-diversified portfolio. Because government bonds are risk-free assets, it reduces the overall portfolio risk.
Regular Income
According to RBI norms, interest on government bonds must be paid to bondholders every six months. As a result, it allows bondholders to generate a consistent income by investing their idle funds.
Disadvantages of investing in Government Bonds
The following are the disadvantages of investing in government bonds.
Low Returns
The yield or interest earned on government bonds is relatively lower in comparison to other investment options like equity, real estate, corporate bonds, etc.
Interest Rate Risk
These are long-term investment bonds with maturities ranging from five to forty years. As a result, the bond’s value may decline throughout this time. When inflation rises, interest rates become less appealing. Furthermore, as the bond period lengthens, market risk rises alongside interest rate risk. Furthermore, the investor is stuck with an investment that pays less than the market value.
Who should invest in government bonds?
These bonds are among India’s most secure investments. It is suited for those who want security and have a low risk tolerance. Investing in market-linked products entails the risk of capital appreciation. As a result, they also function as a long-term investing option for newcomers to the stock market. Government bonds can also be purchased by investors to decrease overall market risk in their investment portfolio.
The Government of India has recently taken numerous initiatives to raise knowledge and appeal of government securities among ordinary investors. They have also simplified the subscription processes for regular investors.
For example, the GOI has implemented a Non-Competitive Bidding mechanism for some government bonds. Market players can quickly put their minimum bid online using this service. Selective websites and mobile applications allow you to put the lowest bid.
Finally, those wishing to diversify/dilute their portfolio can consider investing in government bonds (fixed income instruments). Those looking to start a business can also put their money into government bonds.
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Also Read: The Benefits of investing in Bonds!