Why Investing in Government Bonds is a Good Option

Retail investment in financial markets in India took off after economic liberalisation in 1991, but has mostly remained limited to investments in the equity market. The bond market, which is one of the bedrocks of an economy, has largely remained outside the realm of retail investors in India. Even whatever little retail investment that has gone to bond market is mostly through mutual funds.   
 

The bond market in India primarily consists of two segments – corporate bond market where companies raise funds and government bond market where the government raises funds to finance fiscal deficit. India has a thriving government bond market, which is dominated by institutional players like banks, insurance companies and pension funds. Comparatively, the volumes in corporate bond market are much less.  
 

But things are changing slowly but surely with the Reserve Bank of India starting the Retail Direct Scheme, which has allowed individual investors to access government bond market directly.   
 

The recent interest rate hikes by the RBI since 2022 to moderate inflation has also whetted the appetite of retail investors in bonds as evidenced in the number of retail bond platforms that have come up in recent years.  
 

Why should one invest in government bonds?  
Investments in governments bonds are an effective way of diversifying one’s risks. They are virtually risk-free as there is a sovereign guarantee to these bonds. Government securities carry practically no risk of default and, hence, are called risk-free gilt-edged instruments.  
 

Though corporate bonds offer higher interest rates compared to government bonds, they carry much higher credit risk and are less liquid – higher the credit risk of a bond, higher the interest rate that it offers. There is virtually no risk if the government bond is held to maturity. One can be assured of a steady stream of interest income from a government bond. There can be capital gain or capital loss, if one sells the bond before maturity, depending on the prevailing interest rates.  
 

What are government bonds?  
Government bonds are securities issued by the Central government and state governments to fund their fiscal deficit or other expenditure needs. These can be dated government securities, state development loans, or treasury bills.   
 

Currently the longest maturity government bond is 50 years. The coupon payments on these bonds can be fixed or floating. In a fixed rate bond, the coupon will be fixed for the life of the bond whereas in a floating rate bond, the coupon is re-set at regular intervals. The government also occasionally issues capital indexed bonds, inflation indexed bonds, sovereign gold bonds and sovereign green bonds. Sovereign gold bonds are government securities denominated in grams of gold. Investors pay the issue price in cash and the bonds, which were introduced as a substitute for holding physical gold, are redeemed on maturity in cash at the prevailing price of gold.   
 

There are also short-term instruments called treasury bills with original tenors of less than a year. The three tenors in which the government issues treasury bills are 91 days, 182 days and 364 days. Treasury bills are zero coupon securities issued at a discount. The government also occasionally issues cash management bills to meet the temporary cash flow mismatches. These bills are similar to treasury bills but have tenures of less than 91 days.  
 

State development loans are bonds issued by state governments. The state bonds offer a slightly higher interest rate than government securities since they are sub-sovereign. Typically, the spread between 10-year state development loans and government securities is around 50 basis points. However, state development loans are less liquid than government bonds as the total outstanding in such bonds are much less than government bonds.  
 

In addition to these securities, there is a separate market for STRIPS. In STRIPS, the interest payments of the government security is stripped and sold separately. In this case, the principal payment part essentially becomes a zero coupon bond.

Government Bond Market  
Government bond market, which is regulated by the RBI, is dominated by institutional investors such as banks, insurance companies, provident funds and pension funds. Foreign investors in government bond market are likely to increase substantially in the coming months with global bond indices like JPMorgan Government Bond Index-Emerging Markets and Bloomberg Emerging Market Local Currency Index likely to include Indian government bonds in their indices in 2024. Market estimates suggest the inclusion in bond indices will bring in inflows of $25 billion to $30 billion.  
 

There is a steady demand for government bonds from banks as the RBI rules stipulate that banks have to maintain certain part of deposits in liquid assets in the form of cash, gold or government securities, known as Statutory Liquidity Ratio. Currently banks are required to maintain a Statutory Liquidity Ratio of 18% of the deposits.  
 

Why invest in government bonds now?  
The prevailing interest rates are quite attractive with the interest rate cycle in India having peaked. The current 10-year benchmark government bond offers a yield of around 7.1-7.3%, which is more than what most banks offer for fixed deposits.

Government bonds allow you to lock in the interest rate for a long time. The longer the maturity, the higher yields are likely to be. With interest rates likely to head south in the coming months, there is a chance that investors can make a capital appreciation on their investments in the medium-term – bond prices and yields are inversely proportional, that is, when yields (interest rates) fall bond prices will rise.

Since RBI has inflation as a mandate, it is reasonable to presume that inflation in India will not rise sharply in the future, unless there is an exogenous event like the COVID. If the inflation rate in India remains moderate, the current yields will become very attractive in the medium-term to long-term.

Outlook on interest rates  
It is widely believed that interest rates have peaked in India. The RBI is likely to start cutting rates in the second half of 2024 with inflation projected to move closer to central bank’s medium-term target of 4.0%. Once the US Federal Reserve starts cutting rates in May or June, it will be question of time before the RBI follows. Also, the inclusion of Indian bonds in global bond indices will increase demand for Indian bonds and push up their prices, or in other words, bring down yields.   
 

How to Invest?  
One can easily invest in government bonds through RBI Retail Direct, which allows retail investors to maintain a direct retail account with the RBI. The account allows you to make non-competitive bids in primary government bond auctions and trade in the secondary market through the RBI bond trading platform NDS-OM. RBI Retail Direct does not charge any fee. Alternatively, investors can invest through brokers of any of the many bond platforms which allow investors to buy and sell government bonds.  
 

Taxation on Government Bonds  
There are two types of tax on government bonds - one on interest income and the other on capital gains. Interest earned on the government bonds will considered as income and will be taxed as per the income tax slab of the individual. The investor will also have to pay a short-term or long term capital gains tax if he or she makes a profit in trading the bond. Short-term capital gains tax will be applicable at the income tax slab of the individual if the bond is sold before a year. On the other hand, trading of bonds held for more than a year will attract long-term capital gains of 10% without indexation benefits.

Conclusion  
For an investor who is looking to diversify risks, government bonds offer one of the safest bets. It is virtually risk free with the sovereign standing guarantee. They allow investors to lock in funds for a long-period, assuring steady source of interest income. Also, it is probably the best time to lock in the prevailing interest rates as interest rates are likely to ease from here.