Government Bonds- Types Of Government Bonds, Merits And Demerits
Government Bonds- Types Of Government Bonds, Merits And Demerits

In the last few years, the government securities market is has been in the spotlight since foreign investors exit the market, therefore adding a huge volatility to the India Rupee.

Based on a recent report by the Times of India, between May 22-June 18, the amount of money that has been withdrawn by foreign investors from the government Securities market is about $4.5 billion. This action by the foreign investors has led to a depreciation of the Rupee by 4%.

This article will take a look at the Indian government bonds, benefits and disadvantages of investing in the bond market, as well as the inherent risk in the government Securities market. Without further ado, let’s get started.

 

WHAT ARE BONDS?

Simply put, a bond is a loan. Bonds are to a large extent similar to the popular IOU. This is because when you purchase bonds, you are indirectly lending your funds to the bond issuer (the government, bank or corporate entities). The bond issuer is under obligation to pay you interest after a defined period of time. The issuer will also repay the Principal amount as soon as the bond matures. This is exactly why investment in bonds is regarded as a fixed income investment.

It is important to mention here that you can buy and sell bonds at the secondary market, provided there is enough liquidity in the market. A lot of factors such as the perceived creditworthiness of the issuer and interest rate movement may be responsible for the fluctuating price of a bond.

 

WHAT ARE GOVERNMENT BONDS?

When the government needs Funds to finance projects for the overall welfare of the masses, they usually will not increase taxes. Instead, the government will sell bonds for members of the public to invest in. When you invest in such a scheme, the government will pay you interest and your initial principal after a period of time before the bond matures.

Therefore, a government bond can be defined as a bond issued by the Central government and supervised by the Reserve Bank of India. Generally, government bonds are denominated in Rupees, in which case the Indian government will find it difficult to default. At any point that the government plans to default, the media will tag such action as a sovereign debt crisis.

The government only sells bonds when it considers the market to be creditworthy. However, international rating agencies will also roll out a credit rating report about the creditworthiness of the securities market.

 

HOW DO BONDS WORK

The following explains how the bond market works;

  • When you invest in a bond, the issuer borrows your money for a fixed period of time
  • This investment earns you a predetermined interest at regular intervals.
  • The Principal amount will be repaid back to you once the bond matures.

 

DIFFERENCE BETWEEN BONDS AND STOCK

The following are the major difference between bonds and stocks;

  • Stockholders are owners of the company, while bondholders are lenders.
  • Stocks have no fixed time period whereas bonds have a defined term of maturity.

 

BENEFITS OF INVESTING IN GOVERNMENT BONDS

The Indian bond market consists primarily of two categories – the government bonds or G-Sec and the corporate bonds. The government bonds are issued primarily by the RBI on behalf of the government with a view to financing the fiscal deficit. Over the years, government bonds have been considered as a viable investment choice suitable for financial institutions, banks, as well as corporate bodies. However, these bonds are now suitable for individual investors. In view of the above, the following table shows the benefits of investing in government bonds;

 

Benefits Explanation
Risk free Government bonds have always been an ideal example of risk free security. Thus, for investors looking for risk free investment, government securities are best option
Good long term returns These returns are as good as the bank deposits; however unlike bank deposits these deposits are available for longer duration.
Good liquidity Government bonds can be bought and sold like equity products on NDS-OM (Negotiated Dealing System- Order Matching) platform of CCIL. The liquidity in these bonds is good as banks and financial institutions regularly participate in this market.
Diversifies your portfolio With the addition of government bonds funds in your investment portfolio it gets well diversified and the risk mitigates because government securities are considered as risk free.

 

DISADVANTAGES OF GOVERNMENT BONDS

The following are the disadvantages of investing in government bond;

  • The yield or interest paid on government bonds are usually low.
  • Government bonds can lose value after a particular period of time if inflation expectations rise. This is because high inflation will make the interest less attractive.
  • Long-term returns on government bonds are lower compared to properties and equities.
  • Government bonds could be vulnerable especially if the government enters a fiscal crisis.

 

 

VARIOUS TYPES OF GOVERNMENT BONDS IN INDIA

The following are the types of government bonds offered by the Reserve Bank of India;

 

  • Treasury Bills; Treasury bills are short-term government bonds with a maturity period of one year. These bonds are usually issued in three categories – 91 days, 182 days, and 364-day bills. Treasury bill does not pay interest to investors. However, the difference between the face value and the discounted issue price is the investors’ profit. The RBI as part of its weekly routine issues the bills.

 

  • Cash Management Bills: This type of government bonds are short-term Securities that are issued when needed. They are highly flexible. The tenure issue date is largely dependent on government temporary cash needs. Regardless of the chosen tenure, it must be less than 91 days. It is also similar to the Treasury bill in that the RBI will issue it at a discount on the real value.

 

  • Dated Government Securities: This particular type of government bonds has a varied rate of interest. The investors will benefit when the interest is paid on the bonds. Dated Government Securities are termed “dated” owing to the predetermined date of maturity. The Reserve Bank of India sells these bonds on auction. Example of investors in this category is insurance companies and commercial banks. The following are an example of the dated government Securities;

○    Fixed and floating rate bonds

○    Zero coupon bonds

○    Capital index bonds

○    Bonds with a call or put option.

 

  • State Development Loans: State government loans are government bonds although issued by the State government with a view to meeting their budgetary requirements. The RBI facilitates the issuance of these bonds via the negotiated dealing system. They are usually issued once every two weeks. The interest rate is higher than that of the Dated Government bonds, but it is determined only during the auction.

 

RISKS INVOLVED IN GOVERNMENT BONDS

Investment in government bonds comes with its own inherent risks. The prices may plummet, the market itself may fall or the bond may not do well. Your investment value may dip and rise depending on Market forces.

Market performance in the past is not an indication of a better performance in the future. In view of all these, we would now consider the risks that are inherent in government bonds.

 

  • Credit risk: Simply put, credit risk is the inability for the government to pay interest and the Principal as at when due. Rating agencies like Fitch, Moody, and Standard & Poors (S&P) will usually assess the creditworthiness of the issuer to determine whether they will be able to pay interest and principal as at when due. The rating score range from AAA to D. These scores will enable an investor to determine which issuer will default in terms of interest payment. An issuer with a rating score of D will be considered as a speculative bond and hence a subject of volatility.

 

  • Inflation Risk: Generally, inflation affects the purchasing power of the interest that would have been paid to investors. Since bonds do not offer high interest, during inflation the little interest paid would be unattractive. However, Inflation Linked Bonds are designed to protect the interest of investors during inflation. The Principal and interest increase with respect to an increase in inflation.

 

HOW TO INVEST IN GOVERNMENT BONDS

The Indian bond market consists primarily of two categories – the government bonds or G-Sec and the corporate bonds. The government bonds are issued primarily by the RBI on behalf of the government with a view to financing the fiscal deficit.

Over the years, government bonds have been considered as a viable investment due to good liquidity and lesser risk. Investors can buy government bonds or G-Secs directly from the exchange via a brokerage house that offers the bonds for sale.

Currently, the bond market does not have enough liquidity, so most buying and selling are done on the counter (OTC). So, investors can invest in government bonds through Mutual funds. Doing so, the AMC will be responsible for providing liquidity, which of course is a better idea.

 

 

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