Types of Government Bonds in India
The government bonds market in India is huge. While India's total bonds market size is $1.8 trillion, 65% of this or around $1.2 trillion, is invested in Government bonds.
This article explores and discusses the various types of government securities in India.
Types of Government Bonds in India
We can classify all government securities into four categories based on two factors:
- Issuer (central/state government)
- Tenure (short/long term)
This gives us broadly four types of securities:
Short-term securities issued by the central government
Primarily two short-term securities are issued by the central government:
- T-bills or Treasury Bills
- CMBs or Cash Management Bills
T-bills or Treasury bills
T-bills are short-term government bills. They are money market instruments, meaning those with a life or tenure of less than one year. T-bills could have one of the following 3 tenures:
- 91 days
- 182 days
- 364 days
Unlike normal bonds that pay regular interest, treasury bills are zero coupon bonds. They are not sold at face value (a round value like Rs. 1,000) but at a discount to the face value (a value like Rs. 950). The investor receives the face value (a round value like Rs. 1,000) on the maturity date of the treasury bill.
CMBs or Cash Management Bills
Cash Management Bills are short-term government bills. They are similar to the treasury bills we discussed above but have shorter maturities than T-bills of less than 91 days.
CMBs were first issued in 2010 to adjust temporary mismatches in the central government’s cash flows.
Long-term securities issued by the central government
Central government long-term bonds are also called Dated G-secs or Dated Government Securities. Dated G-secs make up the biggest market within the government bonds universe.
Dated G-secs typically have the following characteristics:
- Fixed interest rate
- Half-yearly coupon/interest payment
- Tenure between 5 and 40 years
- Min investment of Rs. 10,000
The RBI (Reserve Bank of India) classifies Dated G-secs into 10 types of instruments. We discuss them in detail in the following sections.
Fixed-rate bonds are the most common Dated G-Secs issued by the central government. They have a fixed interest rate that doesn’t change throughout the bond’s life. This means that bondholders will receive the interest at a constant rate.
Floating rate bonds (FRBs)
Floating-rate bonds with variable coupon rates have coupon rates that vary over the bond’s life. The coupon rates may be linked to the interest rate of a different instrument and have a spread (extra interest) over it.
For example, Floating Rate Savings Bonds, 2020 (Taxable) or [FRSB 2020 (T)] have an interest rate that is linked to the interest rate of the National Savings Certificate (NSC). The interest rate of FRSB 2020 (T) varies as follows:
Interest rate of FRSB 2020 (T) = Interest rate of NSC (base) + 0.35% (spread)
Zero coupon bonds
We saw T-bills and CMBs as examples of zero coupon bonds above. However, they are short-term zero-coupon securities. Even long-term securities like Dated G-secs could be zero coupon bonds.
However, the central government hasn’t issued long-term zero-coupon bonds after 1996.
Capital Indexed Bonds
Suppose you invest Rs. 10,000 in a 10 year normal bond and receive payments for 10 years. At maturity, you will be paid the initial investment of Rs. 10,000 back. The problem is that the value of Rs. 10,000 after 10 years will be much less than when you made the investment.
Capital Indexed Bonds protect your capital against inflation. When a Capital Indexed Bond is issued, it promises to inflate your principal amount at a predetermined rate. Let’s look at a simple example of a Capital Indexed Bond with the following characteristics:
- 10% interest rate
- Assumed inflation 8%
- Annual interest payment
- 1 year tenure
Investing Rs. 10,000 in the above Capital Indexed Bond will pay you Rs. 1,000 as interest at the end of the year but return your investment on an inflation-adjusted basis. So, you will not receive Rs. 10,000 (your nominal investment) but rather Rs. 10,800 (inflation-adjusted investment)
Inflation Indexed Bonds (IIBs)
Inflation Indexed Bonds or IIBs go further than Capital Indexed Bonds. While Capital Indexed Bonds protect your investment or principal from inflation, IIBs aim to protect your principal and interest payments from inflation.
So, not only will your principal grow with inflation, and the interest payments you receive will grow at an assumed inflation rate.
While popular in developed markets like the US and the UK, IIBs were last issued in 2013 and received a tepid response.
Bonds with call/put options
Call and put options are generally related to trading in the Futures and Options market. However, bonds may also have embedded call/put options.
A bond call option gives the issuer the right to ‘call the bond back’ before maturity. When this option is exercised, investors are forced to sell the bond back to the issuer at a predetermined price and the interest payments stop.
On the other hand, a put option gives the bondholder the right to ‘put the bond back’ to the bond issuer before maturity at a predetermined price.
Special securities are unique because they are not sold to retail investors but rather to corporations on an ad-hoc basis to compensate them for cash subsidies or recapitalise a public sector bank.
Special securities are usually long-dated and carry a slightly higher interest rate than the yield available in the market during the time of issue. Further, special securities can be used only by financial institutions (like banks and insurance companies) in the repo market as collateral.
This works as follows:
- The government compensates companies like oil companies or fertilizer companies with special securities
- The companies sell the special securities to financial institution(s)
- The companies get funds while the repo market is enhanced with more collateral
Separate Trading of Registered Interest and Principal of Securities (STRIPS)
STRIPs are an interesting security. They strip the principal and interest of a normal government bond into two different securities, and both the securities trade separately.
Sovereign Gold Bonds (SGBs)
Sovereign Gold Bonds (SGBs) were introduced in 2015 under the Gold Monetization Scheme. They have become immensely popular right from the first issue and have been issued regularly to satisfy their high demand.
The returns from these bonds are linked to the price of gold. Also, the units you buy are denominated in units of gold. In other words, you can’t invest an amount of your choice in SGBs but rather buy 1 gram worth of SGB or 10 grams worth of SGB.
Another advantage SGBs have over other methods of gold investment (physical, ETF, mutual fund etc.) is that SGBs offer a 2.5% interest rate. This interest rate is over and above the appreciation in the price of bonds which is linked to the price of gold.
A downside of investing in SGBs is the lock-in period of 5 years applicable to them.
Read this article to understand more about Sovereign Gold Bonds.
7.75% Savings (Taxable) Bonds, 2018
7.75% Savings (Taxable) Bonds, 2018 were issued by the Government of India in 2018. They had a tenure of 7 years with varying lock-in periods depending on the investor's age.
Short-term securities issued by the state government
State governments do not issue short-term securities. They only issue long-term securities known as State Development Loans (SDLs) for periods of 10 years and longer. We discuss SDLs in this article a few paragraphs later.
Long-term securities issued by the state government
State governments have various sources of funds/revenue: taxes, duties, loans from the central government etc. But most states have a deficit between their revenue and expenditure. They try to fund this deficit by issuing State Development Loans (SDLs).
State Development Loans (SDLs)
SDLs are long-term bonds offered by state governments. Just like bonds issued by the central government, SDLs are also managed by the RBI. They also carry the same ‘sovereign guarantee’, making them super safe for investment.
However, to keep the state borrowing in check, the central government has limits how much each state can borrow.
SDLs have the following characteristics:
- Lower risk than even AAA-rated corporate bonds
- 10 year tenure (longer in some cases)
- Higher yields than long-term central government bonds (Dated G-secs)
- Fixed interest rate
- Half-yearly interest payment
While SDLs have higher yields than central govt bonds, the yields among different SDLs vary too. States with higher fiscal deficits offer a higher yield as they are viewed as riskier than states with better fiscal positions.
Now that we know about all the types of government bonds, we can compare the 3 most important types of government bonds: Dated G-Sec vs. T-Bill vs. SDL