Government Bonds

Government bonds are debt instruments issued by central and state governments to raise money for public spending and development. They generally carry low credit risk because repayment is backed by the issuing government.

• Investors may receive fixed or floating interest payments.
• The principal is repaid when the bond matures.
• Maturity periods may range from less than 1 year to 30 years or more.
• Common types include fixed-rate bonds, floating-rate bonds, zero-coupon bonds and inflation-indexed bonds.
• Bond prices may change because of interest rates, inflation, demand, supply and the remaining maturity period.

• Government bonds carry low credit risk, but they may still involve interest rate, inflation, liquidity and reinvestment risks.

  
  
  

A government bond is a fixed-income security through which you lend money to the government for a specified period. In return, the government generally pays interest and repays the principal amount on the maturity date.
Government securities issued by the Central Government in Indian rupees are considered free from credit risk. However, their market prices can still rise or fall because of changes in interest rates and other market conditions.
In India, government securities are issued through the Reserve Bank of India. They include short-term Treasury Bills and longer-term dated government securities.
Government bonds may suit investors who want relatively stable income and lower credit risk. However, returns are not guaranteed when bonds are sold before maturity because their market prices may change.
 

Here are the main characteristics of government bonds in India:

• Fixed maturity: A government bond has a predetermined maturity date. This is the date on which the government must repay the principal amount.
• Interest payments: Coupon-bearing bonds provide interest payments at specified intervals until maturity.

• Debt securities: Governments issue these bonds to raise money for purposes such as infrastructure spending, budgetary requirements and public welfare programmes.

  
  
  

When you buy a government bond, you lend money to the government for a specified period. In return, you may receive interest payments known as coupon payments.
At the end of the bond’s term, the government repays the principal amount. This date is called the maturity date.
Some government securities mature in less than a year, while long-term securities may have maturities of 30 years or more. Before investing, it is useful to understand the following terms:

• Maturity: Maturity is the period from the bond’s issue date to the date on which it becomes repayable. The maturity date is when the principal amount becomes due.
• Principal: Principal refers to the initial amount invested in the bond. It is also called the face value and is the amount the issuer promises to repay at maturity.
• Bond price: The issue price is the price at which a bond is originally offered. After issuance, its market price may rise or fall because of interest rates, demand, supply and other market factors.
• Coupon rate: The coupon rate is the annual interest rate applied to the bond’s face value. It is decided when the bond is issued, unless the bond has a floating interest rate.
• Coupon date: Coupon dates are the scheduled dates on which interest is paid to bondholders. Most dated government securities in India pay interest every six months, although payment terms depend on the security.
   

India has different types of government bonds to meet varied investment requirements. The main types are explained below.

1. Fixed-rate bonds

Fixed-rate bonds pay interest at a rate that remains unchanged throughout the bond’s tenure. Their coupon rate does not change when market interest rates rise or fall.

Most dated government securities in India are fixed-rate bonds. Their names usually mention the coupon rate and maturity year.

For example, a bond carrying a 7% annual coupon pays interest calculated at 7% of its face value. The market price of the bond may still change after it is issued.

Fixed-rate bonds provide predictable interest payments. However, their market value may fall when prevailing interest rates rise.

2. Floating-rate bonds

Floating-rate bonds do not have a fixed coupon rate for their entire tenure. Instead, the interest rate is linked to a benchmark and is reset at specified intervals.

For example, the coupon rate may be revised every six months. Some floating-rate bonds have a benchmark rate plus a fixed spread.

The benchmark component may change, while the spread generally remains fixed throughout the bond’s tenure.

3. Sovereign gold bonds

Sovereign Gold Bonds were introduced in 2015 as an alternative to holding physical gold. They were issued by the Reserve Bank of India on behalf of the Government of India.

Each bond is denominated in grams of gold. Its value is linked to the market price of gold rather than a fixed redemption amount.

The issue price was calculated using the simple average closing price of gold of 999 purity during the three working days before the subscription period.

SGBs have a tenure of 8 years. Premature redemption is allowed after the fifth year, but only on an applicable interest payment date.

They pay interest at 2.5% per year on the original investment amount, with payments made every six months. The interest is taxable according to the applicable income tax rules.

For individual investors, capital gains arising from redemption through the RBI are exempt from tax under the applicable provisions. Tax treatment may differ when bonds are sold on a stock exchange before redemption.

SGBs may be held in certificate form or in dematerialised form.

4. 7.75% GOI Savings Bonds

The Government of India introduced the 7.75% Savings (Taxable) Bonds, 2018, to replace the earlier 8% Savings Bonds.

These bonds paid interest at a fixed rate of 7.75% per year. The interest was taxable according to the investor’s applicable income tax rate.

The minimum investment was ₹1,000, and further investments had to be made in multiples of ₹1,000. The bonds had a maturity period of 7 years, subject to specific premature redemption provisions for eligible senior citizens.

Fresh subscriptions to the 7.75% Savings Bonds were discontinued in May 2020. Therefore, investors can no longer make new investments in these bonds.

5. Inflation-indexed bonds

Inflation-indexed bonds are designed to provide some protection against inflation. Their returns are linked to an accepted inflation index, such as the Consumer Price Index or Wholesale Price Index.

Depending on the bond’s structure, the principal, interest or both may be adjusted for inflation.

A Capital Indexed Bond is a type of inflation-linked bond in which the principal amount is adjusted according to the specified inflation index.

These bonds aim to protect the real value of the invested amount. However, their actual structure and returns depend on the specific terms of the issue.

6. Zero-coupon bonds

Zero-coupon bonds do not make regular coupon payments. Instead, they are generally issued below their face value and redeemed at face value on maturity.

The investor’s return is the difference between the purchase price and the amount received at maturity.

For example, a bond purchased for less than its face value may be redeemed at its full face value. The difference represents the investor’s return before taxes and other costs.

7. Bonds with call or put options

Some government bonds may include call or put options.

A call option allows the issuer to repay the bond before its original maturity date according to the bond’s terms. A put option allows the investor to ask the issuer to repay the bond early on specified dates.

These options can generally be exercised only after the period and on the dates stated in the bond’s issue terms. The three possible structures are:

• Bonds with only a call option
• Bonds with only a put option

• Bonds with both call and put options

  
  

The price and repayment terms depend on the conditions specified when the bond is issued.

Government bonds may provide regular income and lower credit risk. Investors can choose among different types depending on their investment period, income requirements and ability to accept price fluctuations.

However, government backing does not mean that every bond will provide a fixed market value. Investors who sell before maturity may receive more or less than the amount originally invested.

Several factors may affect the market price of government bonds.

1. Supply and demand

Government bond prices are affected by demand and supply.

The supply changes when the government issues new securities. Demand depends on factors such as interest rates, inflation expectations, liquidity and the bond’s remaining maturity.

When supply is higher than demand, bond prices may fall. When demand is higher than supply, prices may rise.

2. Interest rates

Interest rates and existing fixed-rate bond prices generally move in opposite directions.

When market interest rates fall below a bond’s coupon rate, the bond may become more attractive. Its market price may therefore rise.

When market interest rates rise above the bond’s coupon rate, newly issued bonds may offer better returns. The market price of the existing bond may then fall.

3. Maturity date

A bond’s remaining maturity period can affect how much its price changes.

As a bond moves closer to maturity, its price generally moves towards its face value, provided there is no repayment concern. It also usually becomes less sensitive to interest rate changes.

Long-term bonds are generally more sensitive to interest rate movements than short-term bonds. As a result, their market prices may experience larger changes.

4. Inflation

Inflation reduces the purchasing power of fixed interest payments and the principal amount.

When inflation rises, central banks may increase interest rates to manage price pressures. Higher interest rates can reduce the market value of existing fixed-rate bonds.

Therefore, high inflation may affect bondholders through lower purchasing power and falling market prices.

Government bonds may suit investors who prefer lower credit risk, capital preservation and relatively predictable income.
They may be considered by risk-averse investors who do not want their entire portfolio to be exposed to equity market movements. However, government bonds are not free from market risk when sold before maturity.
Coupon-bearing government securities may also suit investors who want scheduled interest payments. These may include retirees or investors seeking regular income.
Government bonds can also be used for diversification. For example, an investor with a large allocation to equities may add government securities to reduce the portfolio’s overall exposure to equity market volatility.
However, government bond interest is generally taxable in India unless a specific exemption applies. The tax treatment depends on the type of security, holding period, method of sale or redemption, and the investor’s circumstances.
Investing in government securities may be easier to understand than investing in some market-linked products. Still, you should review the bond’s maturity, yield, coupon rate, liquidity and tax treatment before investing.
 

Government bonds provide several benefits, but they also involve certain limitations and risks.

Advantages of government bonds

1. Sovereign backing
Central government securities issued in Indian rupees carry the repayment obligation of the Government of India. They are therefore considered free from credit risk in the domestic market.
However, this does not protect investors from changes in the bond’s market price before maturity.

2. Inflation protection
Certain securities, such as inflation-indexed bonds, are designed to reduce the effect of inflation on investment returns.
Depending on the bond’s terms, the principal, interest payment or both may be adjusted according to an inflation index.

3. Steady income stream
Coupon-bearing dated government securities generally pay interest every six months. This can provide a scheduled income stream during the bond’s tenure.
However, the amount and payment frequency depend on the terms of the particular security.

Disadvantages of government bonds

1. Lower returns
Government bonds generally carry lower credit risk than corporate bonds. As a result, they may also provide lower yields than securities carrying greater credit risk.
This may make them less suitable for investors whose main aim is higher capital growth.

2. Long-term commitment and inflation risk
Some government bonds have maturity periods ranging from a few years to several decades.
Over long periods, inflation may reduce the real value of fixed interest payments and the principal. Inflation-indexed bonds may provide some protection, depending on their structure.

3. Risks of government bonds
Government bonds carry low credit risk, but they are not free from all investment risks. The main risks are explained below.

4. Interest rate risk
Bond prices generally fall when market interest rates rise.
You may face a capital loss if you sell a fixed-rate bond before maturity when its market price is below your purchase price.

5. Inflation risk
Inflation may reduce the purchasing power of fixed coupon payments and the principal amount.
When inflation is higher than the return from the bond, the investment may produce a negative return after adjusting for inflation.

6. Liquidity risk
Some government securities are actively traded, while others may have fewer buyers and sellers.
If a security is not actively traded, you may find it difficult to sell it quickly at the expected price.

7. Reinvestment risk
Reinvestment risk arises when interest payments or maturity proceeds must be reinvested at a lower interest rate.
This can reduce the total income you earn from your investments, particularly when market interest rates are falling.

8. Policy risk
Changes in government borrowing, fiscal policy, monetary policy or debt-management practices may affect bond prices and yields.
These changes can create price movements for investors who buy or sell government securities in the secondary market.
 

Inflation risk is the possibility that rising prices will reduce the real value of your bond investment. When inflation is higher than the bond’s return, the purchasing power of the interest and principal decreases.
Inflation-linked securities may offer better protection against this risk. However, you should consider the following points before investing in government bonds.

1. Understand the available government bonds
Different government securities have different maturity periods, interest structures, liquidity levels and risks.
Understanding these differences can help you select a security that matches your financial requirements.

2. Consider your investment objectives
Your decision should be based on your investment objective, time horizon and risk tolerance.
Government bonds may be suitable when your main goals are capital preservation and regular income. However, they may not suit investors seeking higher growth or easy access to funds at all times.

3. Stay updated on economic events
Inflation, interest rates, monetary policy and government borrowing can affect government bond prices and yields.
Following these factors can help you understand why the market value of your bonds may change.

4. Diversify your portfolio
Diversification means spreading your money across different types of assets instead of relying on a single investment.
Holding a combination of assets such as equities, bonds and real estate may help reduce the impact of a downturn in one particular asset class.
 

Government bonds can provide relatively stable income, lower credit risk, and portfolio diversification. However, they are not completely risk-free, as their prices may change due to interest rates, inflation, liquidity, and market conditions. Before investing, consider the bond’s maturity, coupon rate, yield, tax treatment, and your financial goals. Choosing the right type of government bond can help you balance safety and income, but you should understand the terms and risks before making an investment decision according to your risk profile.