What are Government Bonds?
While considering the definition of government bonds, it is important to understand that they serve as debt instruments that are issued by the central and state governments of the country. These bonds are usually issued when the issuer is facing a liquidity crisis and needs funds so that they can develop infrastructure.
In India, a government bond can be understood to fall under a relatively broad category of government securities (or G-secs). They can be issued for a tenure of 5 to 40 years, acting as a long-term investment instrument. The central and state governments are authorized to issue these bonds. In the latter case, the bond may also be referred to as a state development loan.
While G-secs were originally issued with the aim of targeting large investors ranging from companies to commercial banks, the government has now made provision to make government securities accessible to small investors. These include individual investors as well as co-operative banks.
Various bonds are issued by the central and state governments, targeting different investment objectives of the investors.
Also known as coupons, the interest rates governing government bonds can exist in a fixed or floating form, distributed semi-annually. Usually, however, most of the bonds issued by the Government of India are at a fixed coupon rate made available in the market.
Types of Government Bonds
A wide variety of government bonds exist, some of which are examined below.
Fixed Rate Bonds – The interest rate applicable to these government bonds is fixed for the entire tenure of the investment, regardless of the fluctuations in market rates. The coupon on government bonds has been determined as follows. For example, 6.5% GOI 2020 implies an interest rate of 6.5% on the face value of which the Government of India is the issuer and the year of maturity is 2020.
Floating Rate Bonds (FRBs) – These bonds are variable based on the periodic changes experienced by the rate of return. The intervals over which these changes take place are clarified before the bond is issued. These bonds can also exist with the interest rate divided into a base rate and a fixed spread. This spread is determined through auction and remains fixed till maturity.
Sovereign Gold Bond (SGB) – Under this scheme, entities are allowed to invest in digital forms of gold for an extended period without availing gold in its physical form. The interest generated through these bonds is tax-free. The price of these bonds is tied to the price of physical gold. Typically, the face value of an SGB is calculated by computing the simple average of the closing price of gold, which has a purity level of 99 percent, three days prior to the issue of the bond in question.
There exist limits that are placed on the amount of SG an individual entity can hold. Different entities apply different ceiling levels. The liquidity of SGBs is possible after a period of 5 years. However, redemption is possible only on the date of interest distribution.
Inflation-indexed bonds – Acting as a unique financial tool, the principal and interest earned on such bonds are inflation-inflated. Typically, these bonds are issued to retail investors and are indexed according to the Consumer Price Index (or CPI) or the Wholesale Price Index (or WPI). Real returns are possible with the help of these bonds as the investment remains stable and allows investors to protect their portfolios against varying inflation rates.
7.75% GOI Savings Bond – This government security was introduced in 2018 to replace the 8% savings bond. The interest rate applicable here is 7.75%. RBI says these bonds can be in the possession of individuals who are not NRIs, minors or Hindu Undivided Families. The interest earned through these bonds is taxable as per the Income Tax Act of 1961, taking into account the income tax slab of an investor. Bonds are also issued with a minimum amount of Rs 1000 and in multiples of Rs 1000.
Bonds With Call Or Put Option – What makes these bonds different is that the issuer is entitled to buy back such bonds through a call option or the investor has the right to sell it to the issuer with a put option.
Zero-Coupon Bonds- These bonds do not earn interest. Instead, investors earn returns through the difference between the issuance price and the redemption price. They are not issued through auction, but are created through existing securities.
Pros and Cons of Investing in Government Bonds
There are a number of advantages and disadvantages associated with investing in government bonds, some of which are examined below.
Some of the benefits of investing in government bonds include the following.
- They provide a sovereign guarantee to the investors.
- They are inflation-adjusted instruments and give investors an edge.
- They provide a regular flow of income to the investors. The disadvantages associated with investing in government bonds include the following.
- Except for the 7.75% savings bonds of the Government of India, the interest-earnings on other government securities bonds are low.
- Due to the fact that these bonds are issued for a longer period, they have the potential to lose relevance over time.
Investors should read the fine print before investing in any given security. Government bonds serve as viable instruments as they are adjusted according to the level of inflation and are issued by the government itself.