11 Mins

Introduction

Bonds are debt instruments in which the investor loans money to an entity. The entity borrows money at a fixed interest rate for a specific time duration. Such an entity can be government, banks or corporates. Hence, when the government issues bonds, they are known as government bonds. Furthermore, these investments are known as fixed income investments.

Here, in this article, we have covered in detail about government bonds, its types, advantages and disadvantages. 

What are Government Bonds?

A government bond is a debt instrument issued by the central and state government of the country to finance their needs and also to regulate the money supply. When the government requires funds for infrastructure development and for financing government spending such bonds are often the answer. Thus, the government will sell bonds to the public, inviting investments. The government will pay back the principal and interest as per the clauses mentioned in the bond at the specified maturity date. The government issues bonds under the supervision of the Reserve Bank of India (RBI). 

The RBI issues bonds on behalf of the government of India to finance the fiscal deficit. Over the past few years, the bonds were issued to large market participants like companies, commercial banks and financial institutions. However, in recent years, government bonds have been available to smaller investors like individual investors, co-operative banks etc. Also, individual investors are taking a lot of interest in investing in government bonds. 

Generally, Government bonds in India are long term investment tools. These bonds are for a long duration ranging from 5 years to 40 years. Also, government bonds fall under the broad category of government securities (G-secs). Both the central and state government can issue government bonds. However, the bonds issued by state governments are also called State Development Loans(SDLs).

The Government of India (GOI) issues different variants of bonds. Also, these bonds cater to the diverse needs of the investor. The interest rate offered on the government bond is known as the coupon rate. The coupon can be either fixed or floating disbursed on a semi-annual basis. Mostly, GOI issues bonds which have fixed coupon rates in the market. 

Types of Government Bonds

The following are the different types of Government Bonds.

Treasury Bills

Treasury bills, also known as T-bills, are short term government bonds. They are issued for maturity within one year. The government issues these bonds in three categories, i.e. 91 days, 182 days and 364 days. The investors do not get coupon payments. However, the difference between the face value and the discounted value is the profit for the investors. 

Cash Management Bills

These bonds are short term securities and are highly flexible. They are issued as per the financing needs of the government. Hence, the tenure of the bond is mainly dependent on temporary cash needs. Usually, they must be less than 91 days. It is very similar to treasury bills. 

Dated Government Securities

This type of bond comes with varying rates of interest. The investors will benefit from the interest paid on these bonds. Dated Government securities are termed “dated” owing to the element of the predetermined maturity date. The Reserve Bank of India auctions these bonds. The following are types of dated government securities.

Fixed-Rate Bonds

Government bonds of this nature have a fixed coupon rate throughout the tenure of the bond. In other words, the interest rate remains constant for the entire investment tenure irrespective of the fluctuating market rates. 

Floating Rate Bonds

As the name suggests, the interest rate of these bonds keeps fluctuating during the investment. The interest rate changes are undertaken at intervals which are declared before the bond is issued. 

For example, a floating rate bond (FRB) has a pre-announced interval of 6 months. It means that the interest rate would reset every six months throughout the tenure. 

Zero Coupon Bonds

As the name suggests, Zero coupon bonds have no coupon payments. The profits from these bonds arise from the difference in the issue price and redemption value. In other words, these bonds are issued at a discount and redeemed at par. Further, these bonds are not issued through auction but created through existing securities. 

Capital Index Bonds

The capital index bonds are those where the principal amount is linked to an accepted index of inflation. This bond is issued to protect the principal amount of investors from inflation. 

Inflation Indexed Bonds

The Inflation Index bonds (IIBs) are where the principal amount and the interest payment is linked to an inflation index. The inflation index may be the Consumer Price Index (CPI) or the Wholesale Price Index (WPI). Investments in such bonds ensure real returns which remains constant. Also, it can safeguard the investor’s portfolio against inflation rates. 

Bonds with Call or Put Option

These bonds come with an option where the issuer has the right to buy back the bond (call option), or the investor can exercise its right to sell bonds to the issuer (put option). The investor or the issuer can exercise the rights only after five years from the date of issue. 

Special Securities

The Government of India issues special securities from time to time to entities like oil marketing companies, fertilizer companies, the food corporation of India, etc. The government issues these securities as compensation to these companies instead of cash subsidies.

STRIPS

STRIPS means Separate Trading of Registered Interest and Principal of Securities. Here, each cash flow of a fixed rate bond is converted into individual security. Next, they are traded in the secondary market. Also, they are very similar to zero coupon bonds. However, they are created out of the existing securities. 

Sovereign Gold Bonds (SGBs)

Sovereign Gold Bonds have their prices linked to the price of gold  (commodity price). The nominal value of the bond is calculated based on the previous week’s simple average closing price of 99.99% of purity gold. India Bullion and Jewellers Association Ltd (IBJA) publishes the price list. The denomination of these bonds is in terms of one gram of gold. 

The Central Government issues SGBs where investors can purchase gold without a burden of investing in physical gold. Also, the interest on these bonds falls under tax exemption for individual taxation. Furthermore, investors seeking liquidity from these bonds shall need to wait for the first five years to redeem it. 

7.75% GOI Savings Bond

The GOI savings bond was introduced in 2018 as a replacement for the 8% Savings bond. As mentioned in the nomenclature, the interest for this bond is 7.75%. As per the RBI regulations, these bonds can be held by – 

  • An individual or individuals who are not NRI 
  • A minor with legal guardian representative
  • A Hindu Undivided Family

The interest-earning from these bonds is taxable under the Income Tax Act 1961 as per the investor’s income tax slab rates. The minimum amount for investment is INR 1000 and in the multiples thereof. 

Also, one can use Scripbox’s income tax calculator to calculate their income tax returns.

State Development Loans (SDLs)
The State Government issues bonds to meet their budgetary requirements. Hence, they are known as State Development Loans (SDLs). The RBI facilitates the issuance of these bonds through a negotiated dealing system. Usually, the Government issues security every two weeks. Also, the interest rate of SDLs is higher than the Dated Government Bonds. However, the interest rate of the bond can be known only during the auction. 

Advantages of investing in Government Bonds

The following are the advantages of investing in government bonds.

Risk-Free

Government bonds promise assured returns and stability of funds to investors. They have always been an example of risk-free security. Thus, investors looking for a risk-free investment, government bonds are suitable for them. 

Returns

The returns from government bonds are generally as good as bank deposits. Also, there is a guarantee of principal along with fixed interest. Unlike bank deposits, these bonds are available for a longer duration. 

One can use Scripbox’s returns calculator to estimate their returns. 

Liquidity

One can buy and sell government bonds like equity instruments. The liquidity in these bonds is as adequate as banks and financial institutions. 

Portfolio Diversification

Investment in government bonds makes a well-diversified portfolio for the investor. It mitigates the risk of the overall portfolio since government bonds are risk-free investments. 

Regular Income

As per RBI guidelines, the interest accrued on government bonds shall be disbursed every six months to bondholders. Therefore, it provides an opportunity for the bondholders to earn regular income by investing their idle funds. 

Disadvantages of investing in Government Bonds

The following are the disadvantages of investing in government bonds.

Low Returns

The yield or interest earned on government bonds is relatively lower in comparison to other investment options like equity, real estate, corporate bonds, etc. 

Interest Rate Risk

Government bonds are long term investment bonds where the maturity is ranging from 5 years – 40 years. Hence, the bond might lose its value over this period. If inflation rises, the interest rate is less attractive. Also, higher the bond period, the market risk also increases along with interest rate risk. Furthermore, the investor remains with an investment which is paying below the market value. 

Who should invest in Government Bonds?

Government bonds are one of the safest investments in India. It is suitable for investors who have low-risk tolerance as they prefer security in their investment. Usually, investing in market-linked instruments, there is the uncertainty of capital appreciation. Hence, they also act as a long term investment option for investors who do not have experience in investing in the stock market. Further, investors can purchase government bonds to dilute the overall market risk in the investment portfolio. 

Recently, the Government of India has taken several measures to ensure that government securities gain understanding and popularity among retail investors. Moreover, they have also simplified the methods of subscription for retail investors. 

For instance, GOI has introduced a system of Non-Competitive Bidding for certain government bonds. Through this facility, market participants can conveniently place their minimum bid online. One can place the minimum bid through selective websites and mobile applications. 

To conclude, investors who are seeking to dilute/diversify their portfolio can consider investing in government bonds (fixed income instruments). Also, those who are looking to start their venture can park their excess corpus in government bonds. 

What are the different types of risks while investing in government bonds?

The following are the types of risks while investing in government bonds.

  • Credit risk
  • Inflation rate risk
  • Interest rate risk
  • Liquidity risk
  • Reinvestment risk
  • Market risk

Frequently Asked Questions

What are bond yields?

Bond yields are the returns on the bonds. When the investor buys bonds from the bond markets, they lend money to the issuers. In return, the bond issuers agree to pay interest at the maturity date. The simple way to calculate bond yield is to divide its coupon payment by the face value of the bond. This is also known as the coupon rate. 
Coupon rate = Annual coupon payment/Face value of a bond
The Indian bond markets are enormous markets where different debt instruments are available for investors to invest. 

What are tax-free bonds?

The government issues tax-free bonds to raise money from the public. One of the best examples of tax-free bonds is municipal bonds. As the name suggests, these bonds qualify for tax exemption under Section 10 of the Indian Income Tax Act, 1961. They generally have long term maturity of more than ten years. 

What is a municipal bond?

State government or local bodies issue Municipal bonds. The government uses these funds for socio-economic development through building schools, bridges, hospitals, etc.

What is a municipal bond?

State government or local bodies issue Municipal bonds. The government uses these funds for socio-economic development through building schools, bridges, hospitals, etc. 

What are capital gain bonds?

Capital gain bonds are also known as 54EC bonds. These bonds help investors to claim tax exemption under Section 54EC. An individual can invest in these bonds from the capital gains after selling a property. The two types of ca[pital gain bonds are the National Highway Authority of India (NHAI) and Rural Electrification Corporation (REC.)