Government bonds are a popular form of investment due to their perceived low risk and stable returns. These bonds are issued by governments to finance their activities such as infrastructure development or social programs. However, while government bonds may seem like a safe bet, they are also come with an element of risk. Here are some of the risks associated with government bonds.
What are government bonds?
Government bonds, also known as sovereign bonds or treasuries, are debt securities issued by a national government to raise funds for various public spending needs. When an individual invests in government bonds, they are lending money to the government in exchange for regular interest payments (coupon payments) over a specified period, and the return of the principal amount at the bond's maturity.
What are the main types of government bonds?
India provides a range of government bonds to address the diverse investment requirements of individuals. The following are the most prevalent types of government bonds in India:
- Fixed-rate bonds: Fixed-rate bonds are extended government bonds that offer a consistent interest rate throughout their tenure. The interest rate is determined at the bond's issuance and remains unchanged until maturity. Investors seeking income stability often favor fixed-rate bonds due to the assurance of predictable returns.
- Floating rate bonds: Unlike fixed-rate bonds, floating rate bonds have a variable interest rate that adjusts with the market benchmark. These bonds are market-linked and typically provide a margin over the benchmark rate. The interest rate is periodically reset, offering enhanced protection against inflation resulting from fluctuations in interest rates.
- Sovereign gold bonds: Sovereign gold bonds constitute an enticing government savings initiative designed to promote gold investment without the need for physical possession. Available in both paper and digital formats, these bonds yield an annualized interest rate of 2.5% on the invested amount. The investment's value correlates with gold prices and can be redeemed in cash or physical gold upon maturity.
- 7.75% GOI savings bonds: The 7.75% GOI Savings Bond is a non-transferable government-issued bond providing an appealing guaranteed return of 7.75% per annum. Targeted at retail investors seeking a stable, long-term fixed income security, this bond comes with a lock-in period of 7 years.
- Inflation-indexed bonds: Inflation-indexed bonds function similarly to fixed-rate bonds, but with a crucial distinction – their returns adjust based on inflation. These bonds offer an interest rate linked to either the Consumer Price Index (CPI) or Wholesale Price Index (WPI), safeguarding investors against the erosive effects of inflation.
- Zero coupon bonds: True to their name, zero coupon bonds do not provide periodic interest payments. Issued at a discount to their face value, these bonds mature at par value. The variance between the purchase price and maturity amount serves as the accrued interest for the investor.
Risks involved in investing in government bonds
- Interest Rate Risk
Interest rate risk is a significant factor that investors must consider when investing in government bonds. Bonds are generally inversely proportional to interest rates, meaning that as interest rates rise, bond prices fall, and vice versa. Therefore, if interest rates increase, the price of a government bond will fall, and this may lead to a loss for the investor.
The economic conditions of a country play a significant role in the interest rates. In times of economic growth, central banks may increase interest rates to curb inflation. On the other hand, during a recession, central banks may lower interest rates to encourage lending and borrowing. As a result, it is crucial to keep an eye on economic indicators and market conditions to predict interest rate fluctuations.
- Inflation Risk
Inflation risk occurs when the inflation rate rises and exceeds the yield of a bond, causing the real return on investment to be negative. Investments that do not keep pace with inflation can lead to a significant loss of purchasing power and a decrease in the real value of an investor's principal.
An example: Suppose an investor purchases a ten-year government bond that offers a fixed annual yield of 5%. The inflation rate in India is around 4% during the first year of the bond's ten-year term, which is expected to remain at around the same level for the next few years. However, after the fifth year, there was a sudden spike in the inflation rate of the country, and it jumped to 10%.
In such a scenario, the investor's bond yield of 5% would be below the inflation rate, resulting in negative real returns. That said, due to the sudden surge in inflation, the bond's price in the market would decrease, resulting in a capital loss for the investor if they choose to sell before maturity. Moreover, if the inflation rate remains at a higher level till the bond's maturity, the purchasing power of the bond's future cash flows would significantly diminish, affecting the investors' return.
Investors must consider investing in inflation indexed bonds can be smart choice in such scenarios because they are a type of fixed income investment where the principal amount and interest payments are adjusted for inflation.
- Liquidity Risk
Liquidity risk refers to the possibility of not being able to sell a bond or convert it into cash quickly, easily, or without significant losses. It means that there might be a situation in which there are no buyers or sellers in the marketplace. This can occur because the bond has a low trading volume, there are few buyers and sellers, or there is a lack of depth in the market.
Liquidity risk becomes a concern for investors who may need to sell the bond before its maturity date. If the investor is forced to sell during periods of low liquidity, they may not be able to sell the bond at the desired price, and in extreme cases, they may have to sell the bond at a significant loss. On the other hand, investors who plan to hold bonds until maturity will not be affected by liquidity risk as they will receive the principal and interest, regardless of any market changes that may have occurred in between.
- Credit Risk
Credit risk is a risk that investors face when the issuer of the bond defaults and is unable to pay back the investors' principal and interest. Although government bonds are less prone to default than corporate bonds or equities, this risk still exists. Governments may default on their bonds due to various reasons such as political instability, high debt levels, or economic recession.
Investment in foreign government bonds raises credit risk since it may be challenging for investors to assess the creditworthiness of a foreign government. Additionally, it may be difficult for investors to have any legal recourse if a foreign government defaults on its bonds.
- Currency Risk
Investors who invest in foreign government bonds are exposed to currency risk. Currency risk refers to fluctuations in the value of the currency of the country in which the bond is denominated relative to the investor's home currency. If the value of the currency depreciates against the home currency, the investor's return on investment will decrease.
Moreover, currency risk can also be affected by changes in exchange rates, political instability, or economic conditions. The currency of a country may depreciate due to these reasons, leading to a reduction in the value of the investment.
Wrapping up!
Government bonds are considered low-risk investments. However, they come with some level of risk that investors need to be aware of. While treasury bills are considered risk-free investments, they still come with risks such as interest rate risk, inflation risk, and reinvestment risk. Understanding the risks associated with government bonds is essential to make informed investment decisions and mitigate the risks that come with them.
