What are Government Bonds?
Government bond investment is important to diversify one’s investment portfolio. Government bonds are better and safer financial instruments in India. It is a loan to a company or government that pays specific interest in return. Moreover, these bonds add benefits to investor’s portfolios. Investing in bonds builds wealth over time and provides a better financial future. When a person buys a bond or security, they are essentially extending credit to the issuer.
In the case of government bonds, the issuer is the government. Such bonds are considered a relatively safe investment because they are backed by the government. There are various types of government bonds available to choose from, each with its fundamentals and features. This blog covers “what are government bonds” in detail and further addresses their benefits, risks, types, and more.
Key Takeaways
- Government bonds are loans to the government that pay interest. They are usually safe investments backed by the government.
- There are several kinds of government bonds, including fixed-rate bonds, 7.75% GOI Savings Bonds, and inflation-indexed bonds.
- Government bonds offer steady income, low risk, and high liquidity. They rarely default on payments.
- These bonds have fixed maturity dates and regular interest payments. Their terms can range from 5 to 40 years.
- One can buy government bonds through a Demat account or invest in GILT mutual funds.
Table of Contents
Understanding Government Bonds
Government bonds in India are issued by the Central Government of India under the debt class for investors. These bonds help investors earn steady returns primarily based on government bond interest costs. According to government bonds, these bonds raise funds for various projects that contribute to the country’s development.
The government is liable to pay interest to the bondholders based totally on the government bond interest rates, these interest rates are also known as the ‘coupon rate’. The bondholders receive interest on a fixed date primarily based on the type and holding period of government bonds, additionally referred to as the coupon charge.
Government bonds example: If you buy a 5-year bond for 10,000 rupees, you might get 500 rupees every year for 5 years. At the end, you also get your 10,000 rupees back.
Many people think these bonds are safe because the government usually pays them back on time.
Government bonds in India fall under the government securities category (G-Sec) and are long-term investments, ranging between 5-40 years. These bonds are sponsored with the aid of the creditworthiness and assurance of the Government of India.
Key Characteristics of Government Bonds
The following is the breakdown of some features of government bonds:
- Fixed maturity: Government bonds have a fixed maturity date that determines the period until the government returns the principal to the bondholder.
- Interest payments: Investors receive periodic pre-decided interest payments (called coupon payments) until the bond matures. These interest rates differ from bond to bond.
- Debt bonds: These bonds are debt instruments to raise funds for various requirements, such as financing infrastructure projects, dealing with economic hardship, or social welfare programs.
Types of Government Bonds in India
The following breakdown explains different types of bonds, their fundamentals, characteristics, and how they work:
- Fixed-rate Bonds
A fixed-rate bond is a type of government bond that carries a fixed interest rate that remains constant over the term of the bond. In other words, the interest rate on these bonds does not change with changes in market conditions and interest rates. Most government bonds in India are fixed-rate bonds only. Because fixed-rate bonds offer a steady interest rate, these bonds are ideally suited for investors looking for stable returns on their investments
- 7.75% GOI Savings Bonds
This bond was introduced as a replacement for the G-Sec 8% Savings Bond in 2018. As its name suggests, these bonds’ interest rate is 7.75%. As per RBI rules, these bonds are held by:
- A person or persons who are/are not NRIs in any capacity
- A minor with a legal guardian representative
- HUF (Hindu Undivided Family)
Interest earned on these bonds is taxable under the Income Tax Act, of 1961 as per the applicable income tax slab of investors. The minimum amount of the issuance of these bonds is Rs. 1000.
- Sovereign-gold Bonds
Sovereign gold bonds introduced in 2015 are issued against gold’s weight, i.e., gram. This allows investors to invest in gold without having to physically hold gold jewellery, coins, bars etc. SGBs are government securities issued by the Reserve Bank of India on behalf of the Government of India for a specific period. The value of SGB is related to the value of physical gold. The nominal value of the SGB is calculated by an average closing price of 99.99% purity of gold three days before the issuance of the bond.
SGBs have a minimum tenure of 8 years, however, investors can withdraw funds from their SGBs after the first 5 years. Such liquidity is allowed only on the date of payment of interest. These funds are linked to the market price of gold. Investors can hold SGBs in physical paper form or dematerialised form. The proceeds of such bonds when they mature are tax-free (if redeemed at maturity).
- Bonds with Call or Put Option
Bonds with call or put options have a few unique features. The issuer can buy back the bond, and the investor can sell the bond to the issuer. However, this can only be done on the date of interest distribution after the first 5 years of issuance. There are 3 subtypes in this category, which include bonds with call options only, bonds with put options only, and bonds with both options. The buying and selling of the bond is done on the face value.
- Inflation-indexed Bonds
The inflation-indexed bonds are unique financial instruments, in which the principal amount, and interest rates on such bonds are proportional to inflation. Available primarily to retail investors, these bonds are indexed according to the Consumer Price Index (CPI) or the Wholesale Price Index (WPI). These bonds ensure that the bondholder gets the real returns to remain constant, which is accumulated from investments. This further allows investors to protect their portfolios against the impact of inflation. Capital-indexed bonds are another type of inflation-adjusted securities. Here, the inflation index is only applicable to the capital or principal amount of the balance of investments.
- Floating-rate bonds
Floating-rate bonds are the opposite of fixed-rate bonds. FRBs i.e. floating-rate bonds, do not maintain a fixed interest rate. Instead, these bonds carry a fluctuating interest rate adjusted to the benchmark rate. The interest rate is adjusted at a notified interval in advance, such as every 6 months. This means that the interest rate on these bonds will be reset every 6 months from the issue date to the maturity date. Some floating-rate bonds have a fixed spread and base rate. The line remains relatively stable throughout the bond’s performance.
- Zero-coupon Bonds
Zero coupon bonds are debt securities that do not pay interest periodically like traditional bonds. Instead, these bonds are issued at a discount price to their face value and pay no interest return during the tenure of the bonds. Therefore, these bonds are also called discount bonds or deep discounted bonds.
The investor experiences potential earnings by purchasing zero-coupon bonds at a discounted value and receiving the principal amount at maturity. Zero-coupon bonds are usually long-term investment types ranging the tenure from 10 to 30 years. However, these types of bonds are subject to interest rate risk. If interest rates rise after a purchase, the bond price decreases. In other words, when interest rates fall, the price of the bond rises.
Advantages and Disadvantages of Investing in Government Bonds
The following is the breakdown of several benefits and drawbacks of investing in government bonds:
| Advantages | Disadvantages |
| The government backs these bonds. | Bonds offer low interest rates. |
| Bonds rarely default on payments. | Inflation can reduce bond value. |
| Bonds are easy to buy and sell. | Most bonds have long terms. |
| High liquidity helps quick cash needs. | Long-terms may not suit all investors. |
Who Should Invest in Government Bonds?
Government bonds might be appropriate for investors who have usually low-risk tolerance, and well-planned strategies to meet the financial targets. These strategies also help with factors like where, when, and how much to invest. Bonds are one of the most secure investment ways for investors and can be utilised for effective diversification.
Risk-averse investors who don’t want to spend money on a high-risk or high-return investment may think of investing in government bonds in India. On the other hand, if you already have a high-risk portfolio, you may put money into low-risk government bonds to make certain diversifications. Investing in government bonds, in conjunction with equities, enables you to optimise the risk-to-return balance of your portfolio.
Furthermore, retirees and pensioners looking for a fixed-earning flow of income to cover their daily expenses may find investing in government bonds suitable. The consistent earnings from government bonds can help them meet their daily income desires without taking over excessive risk factors.
What Affects the Price of Government Bonds?
The following are some factors that affect the price of government bonds:
- Interest Rates
Interest rates are closely linked to government bond prices. If the conventional interest rate is lower than the bond’s interest rate, demand for bonds will increase, causing their price to rise accordingly. However, if interest rates are higher than the bond’s coupon rate, demand will fall, leading to a decline in bond prices.
- Date of Maturity
When a bond matures, it affects its price. As the maturity date approaches, the bond price moves to par. As a bond comes to the maturity date, it is usually less affected by market fluctuations. Similarly, longer maturities lead to an increase in the chances of experiencing interest rate risk. This makes the bond more susceptible to market volatility.
- Demand and Supply
Like all financial securities, government bond prices are influenced by the components of demand and supply. The issuance of government bonds is set by the government and changes whenever the government decides to issue new bonds. Demand depends on how effective the bond scheme is to investors. When supply exceeds demand, bond prices fall, and when demand exceeds supply, bond prices rise.
Risks of Government Bonds
Government bonds are generally considered relatively low-risk because they are backed by government assurance. Although these bonds are safer than other investments, they carry the risks. This includes:
- Liquidity Risk
Liquidity risk refers to the risk that the bond cannot be sold before the maturity date. This could be due to the lack of buyers and sellers of bonds in the market. In cases of financial distress, you may have to sell the bond at a lower price, which might result in potential losses.
- Credit Risk
This is the risk where the issuer of the bond cannot repay the principal amount and interest. Usually, government bonds have potentially low credit risk. However, there might be chances where the government can still miss the bond due to various factors such as political instability, recession, rising debt, etc.
- Inflation Risk
Inflation risk occurs when higher rates of inflation will depress the value of your bond investments. When prices rise, the purchasing power decreases. So, if the inflation rate exceeds the bond’s coupon rate, the value of your investment tends to decline. One of the appropriate ways to manage this risk is to invest in inflation-indexed bonds that offer inflation-adjusted returns.
- Currency Risk
Currency risk only occurs when the government bond pays the amount in currency. Exchange rate fluctuations here can reduce the value of your investment.
- Interest Rate Risk
The risk that rising interest rates will cause a bond to fall in value. Bond prices are inversely related to interest rates. If interest rates increase, bond prices will decrease because new bonds will be issued at higher interest rates. This would make existing bonds with low coupon rates less appealing to investors.
How to Invest in Government Bonds in India?
A majority of skilled investors make sure that their portfolios have government bonds for a potential low-risk and consistent-return approach. However, many investors are still confused about how to buy government bonds in India. The following is how you can invest in government bonds in India:
- Open a Demat account: The government lists the G-Secs on numerous stock market exchanges. One can open a Demat and trading account with a registered stockbroker and purchase and sell bonds.
- GILT mutual funds: Investors can put their money in bonds issued by way of the central and state governments using GILT mutual funds. These mutual funds are managed by professional fund managers who make funding choices on behalf of investors.
Conclusion
Government bonds in India generally offer a safe investment. They come in a variety of forms, including fixed-rate, inflation-indexed, and zero-coupon bonds. These bonds offer stable and potentially better returns. They are often chosen by investors and risk-averse retirees. You can buy government bonds through a Demat account or GILT mutual fund. However, the value of government bonds can sometimes be affected by factors such as inflation and changes in interest rates. These bonds, on the other hand, help to diversify portfolios and build wealth over time. They strike a balance between assurance and return. All these reasons make them a wise choice for many investors seeking financial stability.
FAQs on Government Bonds
You lend money to the government when you buy a bond. The government pays you interest regularly and returns your money when the bond ends.
G Sec means government securities. These are bonds the government sells to raise money.
Government bonds are usually a safe investment method and have low risk. They give sort of consistent returns and help balance your investments.
Some of the government bond examples are treasury bills, dated securities, and floating-rate bonds. These are all types of government bonds.
The government often did not levy tax interest on the federal government’s issued bonds. You might need to check your tax forms for bond funds to claim this benefit.