What are Government Bonds – Its Types, Risks, Benefits and How to Invest In Them
Government bonds are low-risk bonds issued by the Government of a nation to collect funds as required. These are beneficial investment opportunities for risk-averse investors, providing steady returns against negligible risks. These assets are a popular investment choice as they help to save tax to a certain extent and provide diversification.
This article provides a detailed overview of government bonds, how they work, their types, how to buy government bonds, benefits and risks associated with them. Read on!
How Do Government Bonds Work?
The Government issues these securities to raise funds against a fixed rate of interest or coupon paid at regular intervals for a predetermined period of time. An investor earns a steady return for the long term until the bond’s maturity.
What Are the Types of Government Bonds in India?
Indian Government Bonds are available for investment by organisations and the public. The Government issues several types of bonds with certain features and perks which appeal to different sets of investors.
1. Sovereign Gold Bonds (SGBs)
SGBs allow investors to invest in Sovereign gold for a long time period and earn tax-free returns at maturity. Sovereign Gold Bonds are virtual assets purchased as a gold investment without the hassle of possessing physical gold.
The value of these bonds is almost equal to the current gold value; however, investors earn a fixed 2.5% interest annually on SGBs. The lock-in period is currently 8 years, but you can redeem it after 5 years with certain conditions.
2. Zero-coupon Bonds
Unlike other Government securities, these bonds earn no interest/coupon on investment. Zero- Coupon bonds are issued at a discount and redeemed at face value, which earns a return for investors.
3. Inflation-indexed Bond
As the name suggests, these bonds are linked to inflation. The principal amount and the interest rate for such bonds are related to inflation and deflation index of the economy. Therefore, these bonds tend to offer constant returns and provide a cushion to investors from effects of inflation. Generally, Consumer Price Index (CPI) and Wholesale Price Index (WPI) are the preferred inflation indices.
4. 7.75% Government of India Savings Bond
These are 7.75% fixed return rate bonds issued at a minimum rate of Rs. 1000 by the Government. Earlier, the return rate was 8% and was recently revised to 7.75%. Unlike a few other bonds, these are not tax-free.
5. Floating Rate Bonds (FRBs)
Floating rate bonds (FRBs) are bonds with fluctuating return rates that depend on market performance. However, the rate of interest changes between fixed intervals which is declared beforehand during the issuance of the bond.
6. Fixed-rate Bonds
Fixed-rate bonds offer a constant rate of interest. The pre-decided interest rate is certain until the investment matures, and it remains unaffected through market fluctuations.
Why Invest in Government Bonds?
Debt securities like bonds have a lower risk measure than stocks. Government bonds are one of the most secure forms of investment attributed to their Sovereign guarantee. They generally pay an interest amount monthly, quarterly or annually, which becomes a stable source of income for an investor. This provides an opportunity for risk-averse investors to earn regular income against a one-time lump sum investment.
What Are the Risks Associated with Government Bonds?
Ideally, Government bond investments are one the most secure investment options and have least risks involved. However, economic and political shifts affect the Government, which directly or indirectly affects the issued bonds.
Unlike developed nations, the Governments of developing nations are exposed to the risks of failure and global threats. These changes can disrupt a country’s economic situation, which in turn may default Government bonds.
Secondarily, in case of a state emergency, the Governments’ priority is not to dissolve bonds; hence, there is no certainty to bondholders, unlike company bonds. Although these risk components are a worst-case scenario and are unlikely to happen, it is important to understand them before going ahead with any investment decision.
How to Buy Government Bonds in India?
Investors can purchase Government securities through various platforms in India. All options to buy G-secs are now primarily online, which has made it easier to trade these bonds.
Government securities are available either directly or as funds and stocks. Investors must have a Demat account to trade Government bonds.
1. Mutual Funds
Investors can invest in G-sec mutual funds through stock exchanges. Government bond funds invest in a pool of government-backed securities, which gives an investor exposure to several bonds with a single investment.
Expert fund managers improve the chances of return. However, an investor must analyse a particular fund’s holdings and track record before investing.
2. Direct Purchase
Government securities are available for purchase on direct platforms of the Government, either with the National Stock Exchange (NSE) or the Reserve Bank of India (RBI) Digital platform. Investors can buy a set of bonds through these sites with a registered account when the Government issues them.
3. Stock Exchanges
Bonds can also be purchased like stocks through various platforms. Investors buy and sell these bonds, and they can also be traded as options. However, it has certain limitations, and this facility is not available for all bonds. Some G-sec ETFs also offer individual units for trading.
4. Banks
Government bonds can be purchased through commercial banks; however, it is important to have a securities account with the bank.
What Affects the Price of Government Bonds?
Several factors affect the performance and prices of a bond. These elements help investors decide if a bond will be the right investment choice.
1. Credit Ratings
Credit rating agencies provide all bonds with a rating, which determines the performance and risk factors associated with a bond. These ratings affect the price of a bond.
2. Maturity Period
The price of a bond also depends on its remaining duration of maturity. New bonds trade at face value with current interest rates. However, a bond at a different stage of its life cycle might be available for a different price.
The maturity period, in general, also affects the bond’s price. Bonds with shorter maturity are more attractive to investors than longer maturity periods because it ensures liquidity. However, longer maturity ensures more stable returns.
3. Demand and Supply
Bond prices fluctuate depending on supply and demand. This is because these bonds are available depending on the fund requirements of the Government. They only issue bonds as and when they need more funds. This supply chain also creates demand for a bond which in turn affects the cost of the bond.
4. Inflation
All commodities and assets in the market are affected by inflation. This also reduces the price of Government bonds in the market in the long term.
5. Interest Rates
An interest rate of a bond crucially affects its demand and price. Attractive interest rates are in high demand among investors, which increases bond prices.
What Are the Advantages of Investing in Government Bonds?
These securities have various advantages for an investor and are comparatively safer than corporate bonds. Some of the pros are discussed below:
1. Safe Investment Option
Government securities have a low risk of default. This advantage attracts investors to buy G-secs without any concern of losing their investments. Additionally, these securities have a negligible chance of losing the principal amount as the Government has sufficient cash reserves even in the worst-case scenario.
2. High Liquidity
G-secs have comparatively high liquidity as they are popular among investors and frequently traded through exchanges. Except for certain long-term fixed securities, most Government bonds have high liquidity, which benefits active investors.
3. Stable Returns
Government bonds provide steady and regular returns based on interest and coupon rates. They even offer better returns than fixed deposit accounts.
What Are the Disadvantages of Investing in Government Bonds?
A Government bond is a long-term investment and thus has several cons that might be unattractive to active investors. Although these securities are safe and are a good option as strategic investments for diversity, they have certain disadvantages that are important to keep in mind while investing.
1. Risk of Interest Rate
Long-term maturity affects the interest returns of these bonds as they tend to lose value over time. Therefore, in the long run, the relevancy of the bond reduces due to rising inflation.
2. Minimum Income
Government securities are considered safe investments with low market risks; however, they also have low returns. This keeps the investors’ money locked in an investment with a lower-than-average return. This aspect can act as a disadvantage for active or aggressive investors.
Final Word
Government-issued securities are good investment assets that provide steady returns for a long time. Therefore, these are useful debt options for the Government to collect funds for public development or other plans. Government Bonds are an important element for diversification of investment portfolios and are effective in saving tax. However, it is important to understand its risks to yield best returns as an investor.
FAQs
Ans: No, all government bonds are not tax-free. However, certain bonds among the different types of Government bonds available are tax-free investments that yield stable returns. One of the best examples of this are Sovereign Gold Bonds or SGBs.
Ans: Government bonds pay fixed returns to their investors over a long period of time. These returns are paid either half-yearly or annually, depending on the agreed terms.
Ans: Government bonds are issued by the Central or State Governments in India. These bonds are usually issued to raise funds for public projects or during a liquidity crisis.
Ans: Bond yields are returns on the bond securities. You can calculate the yield of a government bond by dividing its coupon payment (annual interest rate of a bond) by the face value of the bond.
Ans: Government bonds are guaranteed and backed by a country’s central authority and are thus considered one of the safest investment options for the public. There is minimal to no credit risk with government bonds.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
