Government bonds are debt security or bonds issued by the central or state governments in financing their expenditure and deficit management. You essentially lend money to the government which pays you, in terms of periodic interest payments together with a return of the principal at maturity when you buy such bonds. Government bonds, known for their security and reliability, are very popular among risk-averse individuals and institutions. The government bonds that are provided in India are diversified to cater to the investment needs of various investors. Here’s a comprehensive view of the main types of government bonds in India, how they work, benefits, and associated risks:
Types of Government Bonds in India
Fixed-Rate Bonds
These bonds, since their interest rate is fixed and remains the same throughout the term and does not change with changing market conditions, provide stable predictable returns. It is ideal for conservative investors who demand stable returns. The interest is usually semi-annual; at the maturity date, the investor gets back the principal amount.
Floating Rate Bonds
Whereas in fixed-rate bonds, the rate of interest is fixed and does not change with the passage of time, in floating rate bonds, it periodically varies, which is mainly benchmarked on a Reserve Bank of India repo rate. On a change in the RBI repo rate, the rate of interest on the bond changes accordingly, usually every half-year. In floating rate bonds, in the event of a rising interest rate cycle, the impact of adverse movement of rates the investors are protected as the returns on the bond are reconfigured and in line with the market rate in place at that time.
Inflation-indexed bonds, or IIBs
Inflation-Indexed Bonds are those in which both the principal amount and interest payments vary with the inflation rate as measured by the Consumer Price Index (CPI). The higher the rate of inflation, the higher the returns from the bond, so that the cash that investors have is preserved. Thus, IIBs serve as a boon during times of high inflation, for it ensures that the returns on an investment are not diluted by higher prices since they provide a real rate of return.
Sovereign Gold Bonds (SGBs)
These are issued by the Government of India as an alternative to holding physical gold. They have the benefits of dual advantage: a fixed annual interest rate averaging around 2.5 percent that accrues semi-annually and capital appreciation from a possible appreciation in the price of gold. Thus, for investors seeking this gold asset class, they may find the SGB route as a viable alternative, too, without the hindrances and security risks involved in holding physical gold. Held to maturity, these bonds further provide exemptions on capital gains tax, thus making them more lucrative for long-term investors.
Zero-Coupon Bonds
Zero-coupon bonds do not pay periodic interest. They sell at a discount, and the face value is paid out to the investor at maturity. The return is the difference between the price paid and the maturity value. These bonds are best suited for long-term capital appreciation rather than the generation of periodic income. Because they have a predictable redemption at face value, zero-coupon bonds also have predictability, but cash flow does not exist until the maturity date.
Treasury Bills or T-Bills
Treasury bills are short-term government securities which mature in less than a year, issued at a discount to their face value. There are three maturities of T-bill: 91 days, 182 days, and 364 days. T-bills are favorite investment instruments for risk-averse investors such as banks, financial institutions, or mutual funds seeking a liquid, safe short-term investment option with minimal risk. As the instrument is government-backed, it entails very minimum risk, and thus institutions use the T-bills to manage their cash flows.
State Development Loans (SDLs)
These bonds were issued by state governments to finance specific state-level development projects. SDLs entail a slightly higher yield than the central government bonds on account of the additional element of risk associated with single states. SDLs are relatively risk-free investments and have a fixed rate of interest, thus offering investors an opportunity at diversification and to gain experience of state-backed securities in the government bond market.
Savings Bonds
Savings Bonds, such as the 7.75% Savings (Taxable) Bond, are issued to retail investors who look for secure, long-term investments. They earn a fixed return and most of the interest collected from them is taxable. Special Securities/Bonds appeal to conservative investors who want government-secured investments where returns are assured.
Sometimes the government floats special bonds to finance special kinds of projects, for example, infrastructure building or recapitalizing banks. These are usually institutional investors that accept such types of bonds. The terms and conditions would be unique for such bonds. Callable and Puttable Bonds
Callable Bonds: The issuer, in this case, the government, can call these bonds back before the date of maturity. They do this, for example, when interest rates decline. In this process, the government saves interest paid on the debt. The investors face the risk of premature redemption at a time when they may not be able to reinvest at the same rate.
Puttable bonds: the bonds are repurchased by investors from the issuer prior to maturity and allows investors to surrender the bonds back to the issuer at any time prior to maturity, generally advantageous when interest rates are rising. This feature affords the ability to exit an investment early and potentially reinvest in higher-yielding bonds.
How Govt Bonds Function
Issue and Auction:
Government bonds are priced and sold through auctions conducted by the RBI. In the case of these auctions, any institution, bank, or even retail investor can participate, after which bonds are distributed among the highest bidders. In the case of retail investors, bonds are also available for sale through the RBI Retail Direct, or directly through banks or exchanges .
Coupon Payments:
Most government bonds pay off regular interest. Bonds with a fixed coupon pay out periodically predictable coupon payments; however, floating-rate bonds will make varying amounts indexed to the benchmark rate. With zero-coupon bonds, the investor makes no periodic payments, yet they bring some difference through the discounted purchase price and face value at maturity.
Secondary Market Trading:
Government bonds are secondary market issues. Secondary markets, therefore, provide a liquidity mechanism for investors who need to sell their holdings before maturity. Prices in the secondary market of bonds change with the interest rate and other variables.
Redemption at Maturity:
At maturity, the government pays the principal to the bondholder. In case of T-bill or zero-coupon bonds, it pays the face value to investors when the bond matures, which equals the sum of the return.
Benefits of Investment in Government Bonds
Safety and Security: Government bonds are amongst the safest investment available as it is backed by the full faith and credit of the government.
Income: Periodic interest is paid out of fixed-rate or floating rate bonds, which produces a regular flow of current income.
Portfolio Diversification: Government bonds are one of the best ways in which portfolio diversification can be done. This kind of investment is low risk in nature and it helps to minimize the risk that would otherwise arise from massive stock market fluctuations.
Liquidity: Bonds such as T-bills and other actively traded government securities can be sold off in the secondary markets.
Tax Benefits: Certain bonds like Sovereign Gold Bonds are free from tax on capital gains, if held to maturity, that would enhance post-tax returns
Risks associated with Government Bonds
Interest Rate Risk: Bond prices are inversely proportional to the interest rates and therefore its resale value will change along with the fluctuations in rates.
Inflation Risk: Fixed-rate bonds do not adjust for inflation; hence, the effective purchasing power of returns is reduced during high inflations.
Liquidity Risk: Even though some of the bonds are liquid in character, the other ones may be illiquid, especially state bonds or special securities.
Reinvestment Risk: Interest earned periodically by investors who receive it may face reinvestment risk if they need to invest it when interest rates decline in a declining interest rate environment.
Conclusion
In India, government bonds are available in various forms to suit diverse risk appetite and investment preferences. One can have stability by investing in fixed rate bonds, inflation-indexed bonds would take care of protection from inflation, whereas SGBs would provide exposure to gold. Government bonds serve as a low-risk instrument to create wealth, diversify portfolios, and gain stability of returns.