What are Government Securities and Bonds
Bonds have become an ideal investment instrument for investors who do not want to put all of their eggs in one basket. Here, the basket would be the equity market or any other asset class. If 100% of the capital is allocated to a single asset class, investors may experience a liquidity crisis at the time of a bear cycle when the price of the securities falls sharply and continuously.
Thus, investors look towards debt instruments such as bonds to allow them steady income over time. However, similar to other financial instruments, bonds also include numerous risks. The best way for investors to mitigate the risks involved in bonds is to invest in government securities. This blog highlights the definition of bonds along with the various aspects of Government Securities and Bonds.
What are Bonds, and how do they work?
Bonds are financial instruments that are categorized in the asset class of debt. Bonds create a legal agreement between the issuer and the buyer to allow the issuer to raise a certain amount of funds. Governments or private organizations issue bonds to raise capital while the buyers invest their capital to receive regular interest payments on the principal amount. The bond agreement details the terms of payment (debt servicing) and maturity. The face value (principal) is to be repaid on maturity and can be issued either at a discount or a premium.
Bonds are fixed tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and dependent on various factors such as the credibility of the issuer, maturity, and interest rates in the market.
Bonds work similar to a loan agreement where the bank is the buyer, and the customer is the bond issuer who is looking to raise money for funding certain business operations and deems it fit to raise capital through issuing bonds. When an investor buys bonds, they receive regular interest payments from the issuer with the promise that their principal amount will be repaid at the time of maturity. Furthermore, investors can also trade using the bonds and sell them any time before maturity to realize profits based on the difference in the cost and the selling price.
What are Government Securities and Bonds?
Government bonds, also called government securities, are debt instruments that the country’s government issues to raise capital from the general public. Government bonds can be issued by both India’s central and state governments to ensure they have enough funds for certain operational purposes. Government bonds allow the investors to invest their capital, called the principal amount and receive regular interest payments. The interest payments are made based on the bond rate (coupon rate), which is specified in the government bond contract. Furthermore, government bonds also include the promise to legally repay the principal amount to the bondholder at the end of the maturity period.
Understanding Government Bonds
In the Indian financial market, there are two entities that issuer bonds; the government along with its departments or enterprises and private companies. The bonds issued by the government are called government bonds or G-sec, while the bonds issued by private organizations are called corporate bonds. Governments issue government bonds or securities either to fund certain development or operational activities or when it is going through a liquidity crisis. When governments issue government bonds, they are considered to be lower in risk as it is highly unlikely for the government to have the inadequate cash flow to default on interest payments.
Initially, the Indian government only issued government bonds and securities (G-sec) for large financial entities such as high-net-worth investors, large companies or commercial banks. Later, they decided to offer the government bonds (G-sec) to smaller investors such as cooperative banks, individual investors etc.
There are numerous variants of government bonds and securities issued by the government of India. The coupon rate or the bond rate based on which the interest is paid to the bondholder is either fixed or floating. A fixed interest rate provides the same amount of interest, while a floating interest rate provides a different amount of interest based on fluctuating coupon rates.
Different types of government securities and bonds
The Indian government issues various government bonds and securities (G-sec) to cater to its different funding needs. Here are the types of government securities and bonds:
- Fixed-Rate Government Bonds: Fixed-rate government bonds are issued by the government to offer a predetermined amount as interest at regular intervals. The coupon rate on fixed-rate government bonds (G-sec) remains the same throughout the maturity of the government bonds. For example, a fixed-rate government bond is the 7% GOI 2021 bond that offers a fixed 7% interest to the bondholders.
- Sovereign Gold Bonds: Sovereign Gold Bonds are a type of bond that provides an alternative to purchasing physical gold as tradable security. The Reserve Bank of India introduced Sovereign Gold Bonds in 2015 to allow investors who want to make profits based on the price fluctuations of physical gold to make profits without having to buy physical gold. The Reserve Bank of India issues Sovereign Gold Bonds on behalf of the Indian government, denominated in grams of gold.
- Floating-Rate Government Bonds: As the name suggests, floating-rate government bonds have fluctuating interest rates and provide different interest payments to the bondholders every time. A different variant of such bonds has a base rate and fixed rate. The fixed rate is decided through actuation and remains the same throughout the maturity of the government bond.
- 7.75% GOI Savings Bond: The 7.75% GOI Savings Bond is one of the newest introductions by the government. The savings scheme has replaced the 8% Savings Bond and has a maturity of seven years. Although the interest received on the bond is taxable, it is exempted from the provisions of wealth tax under the Wealth Tax Act, 1957.
Advantages of Investing in government bonds and securities
Within Bonds, investors choose government bonds and securities as they are considered to be one of the most ideal investments for people who do not want to take a high level of risk but earn a steady income. Here are the advantages of government bonds or government securities:
- Negligible Risk: Government bonds and securities come with negligible risk as it is highly unlikely that a government bond would default on interest payments and principal repayment. A government will always have enough cash to fulfil the payment promises and provide interest payments and principal repayment to the bondholders.
- Liquidity: As government bonds and securities are always in demand based on their low-risk profile, they are highly liquid. It means that it is easier for investors to find sellers if they want to sell the government bonds before their maturity.
- Investment Protection: Corporate bonds that are issued by private organizations come with credit risk where the issuer can default or even run away with the bondholders’ money. This is never the case with government bonds as they are backed by the government of a country and do not include the risk of default.
Steady Returns: Government bonds and securities allow investors to earn steady returns based on the regular interest payments. All the government bonds come with a coupon rate which provides periodic interest amounts at regular intervals to the bondholders.
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