Government Bonds in India
Government bonds markets are some of the biggest securities markets in the world. Specifically, the Indian government bond market has a size of more than $1 trillion!
While this sounds huge, it is modest compared to global peers in absolute terms and as a percentage of GDP.
Governments issue bonds to finance welfare and infrastructure projects and the other spending they make for national interests.
Government bonds are often termed ‘risk-free’ because governments have the power to print money. So, even in the worst case, they can print money and return it to their Bonds investors.
But some countries (like Greece, Argentina and Sri Lanka) have defaulted on their debt in the past due to financial stress and overburdening themselves with debt. So, not all government debt is ‘risk-free.’
In this article, we will go in-depth into government bonds and explore them from an investment perspective.
How do Government Bonds work?
Government bonds work just like corporate bonds (bonds issued by companies) but have the following distinctive features.
When you buy a government bond, you essentially lend your money to the government. By being a government bondholder, you receive regular interest payments (coupons) until the bond matures. On maturity of the bond, you get your initial investment back.
For example – Let’s say you have purchased a 10 year G-sec (short form for Government security) worth Rs. 10,000 with a coupon rate of 7%. The bond pays interest twice a year.
By purchasing this bond, you will get annual interest payments of Rs. 700 (7% of Rs. 10,000) split into two equal parts twice a year. Say, Rs. 350 in Jan and July each. This is also called a coupon.
You will get the coupon for 10 years at the end of which your principal (initial investment) of Rs. 10,000 will be returned to you.
That’s how government bonds work if you buy them during the primary issue and hold them until maturity.
What happens when you trade government bonds?
However, government bonds are tradable; you can sell them before they mature. But when you sell them the price could be much lower or higher than your buying price. Let’s see how this works.
You see, the interest rate on your government bond is fixed once you invest. Suppose you invest in a 10Y government bond with an interest rate of 7%.
Scenario 1: A year later, the interest rate of new 10 government bond is 8%
This makes your 7% bond a less attractive option because an investor would choose to invest in the 8% bond rather than your 7% bond. So, if you sell your bond when the prevalent interest rate is higher than the interest rate of your bond, you will have to sell it at a discount.
Scenario 2: A year later, the interest rate of new 10 government bond is 6%
This makes your 7% bond a more attractive option and it would have a greater demand than the new 6% bond. So, if you sell your bond when the prevalent interest rate is lower than the interest rate on your bond, you can sell it for a premium.
The risk that the market rate will be lower than your bond’s rate during the time of sale is called ‘interest rate risk.’
So, while government bonds have little to no ‘default risk,’ they have ‘interest rate risk’ just like any other bond.
Types of government bonds
In India, government bonds are of many types. Let’s look at a few key Types of Government Bonds
Short term government bonds
Government bonds with maturities of less than 1 year are referred to as short-term government bonds.
CMBs or Cash Management Bills are short term government bonds with maturities of less than 91 days.
T-bills or Treasury Bills have fixed maturities of either 91, 182 or 364 days.
Long term government bonds
Long term government bonds have maturities ranging from 5 years to 40 years. They are also called ‘Dated G-Secs’ (short for government securities).
There are many types of long-term government bonds. Fixed rate government bonds, floating rate government bonds, SGBs (Sovereign Gold Bonds) are some of the key long term government bond types.
Long term government bonds pay interest twice a year until maturity and return the principal (initial investment) to the investor at maturity.
State Development loans
Bonds issued by state governments are called ‘State Development Loans.’
Like central government loans, these come with sovereign guarantee too but tend to have a higher interest rate than bonds issued by the central government. This is because state govt bonds are considered to be slightly riskier than central govt bonds.
It is important to note that different states may have different financial strengths. This can be assessed by checking their credit ratings issued by credit rating agencies like CRISIL.
Like date G-secs, SDLs also pay interest twice a year.
Features of government bonds
No credit default risk
Government bonds have little to no default risk. This makes them safer than corporate bonds issued by private companies.
Government bonds have maturities ranging from a few days up to 40 years. This allows you to choose a maturity that suits their portfolio and risk appetite.
Low investment amount
The minimum investment required in a government bond is Rs. 10,000. This makes government bonds accessible to a lot of investors.
Government bonds are tradeable and are the most liquid securities in the country. If you want to sell your government bond before maturity, you will most likely find a buyer on the stock exchange who will buy it from you at a fair price.
No demat account required
Courtesy RBI Retail Direct, now anyone can buy government bonds without opening a demat account. Moreover, the website is 100% free to use and transact.
Can be used as collateral
Government bonds have little to no credit risk and are highly liquid. Hence, banks and other lending institutions accept them as collateral when you borrow from them.
How to invest in government bonds?
There are 2 ways to invest in government bonds. Both are online.
RBI Retail Direct website
RBI Retail Direct is a free website where you can invest in government bonds without requiring a demat account.
All you have to do is open a Retail Direct Gilt (RDG) account on the website and invest.
If you have a demat account, you can invest in and trade in government bonds just like stocks.
The government bonds would be listed in your demat account.