What are Government Bonds & How Do They Work?

Low-risk investments are not only suitable for risk-averse investors looking for fixed-income opportunities; they can also be used by all types of investors looking for portfolio diversification and balanced returns. If you are looking for some fixed-income options, government bonds can be a choice. Let’s find out more about them in this article.

What is a government bond? 

Government Securities (G-Secs) are debt instruments issued by the government to raise funds. They can be short-term, such as treasury bills that mature in less than a year, or long-term, such as dated securities with a maturity of one year or more.

A government bond is a type of long-term G-Sec, also known as a dated security. These bonds are issued by the central or state government to finance public spending and typically offer regular interest payments until maturity. In India, both the central and state governments issue dated securities, like bonds.  

Government bonds are considered low-risk investments and can provide a stable income because they are backed by the government.

How do government bonds work? 

Government bonds are a type of loan where you lend money to the central or state government for a fixed period. In exchange, you receive regular interest payments. Government bond rates can be fixed or variable. Once the bond matures, you get back the amount you initially invested.

Types of government bonds in India 

Government bonds can be categorised into 11 types, as explained below:

1. Fixed-rate bonds: These bonds have a fixed interest rate throughout their tenure to ensure stable returns. Most government bonds in India fall into this category.
2. Floating Rate Bonds (FRBs): The interest rate on these bonds is not fixed and is adjusted periodically based on a pre-set formula, often linked to market rates. The reset interval for the rates could be every six months or one year.
3. Capital-indexed bonds: The principal amount of these bonds is linked to inflation, which helps protect your investment from rising prices. However, only the principal is adjusted for inflation, while interest payments remain fixed. 
4. Inflation Indexed Bonds (IIBs): Unlike capital-indexed bonds, these provide full inflation protection by adjusting both the principal and interest payments based on an inflation index like the Wholesale Price Index (WPI) or Consumer Price Index (CPI). 
5. Bonds with call/put options: Some bonds come with options that allow the issuer to buy them back through a call option or let you sell them back through a put option before maturity. These bonds may have only the call option, only the put option, or both options.
6. Special securities: The government issues these bonds to entities like oil, fertiliser, and food corporations as compensation instead of cash subsidies. These long-term bonds are also referred to as food bonds, fertiliser bonds, and oil bonds. They are considered high-yield government bonds as they usually offer slightly higher interest rates than regular bonds.
7. Recapitalisation bonds: Also known as Special GoI securities, these non-transferable bonds were issued in 2018 by the Government of India to support public sector banks.  
8. Separate Trading of Registered Interest and Principal of Securities (STRIPS): These are zero-coupon bonds created by separating interest payments and principal repayments from an existing government bond. These bonds are not issued through auctions but are constructed out of existing bonds. 
9. Sovereign Gold Bonds (SGBs): These bonds were linked to the price of gold. They allowed investments in gold without physical ownership. However, they have now been discontinued. 
10. 7.75% savings (taxable) bonds, 2018: Launched in 2018, these bonds offered a fixed 7.75% interest rate and could be purchased by resident individuals and Hindu Undivided Families (HUFs). They had no maximum investment limit and were issued in multiples of ₹1,000. However, the government withdrew these bonds, effective May 28, 2020. 
11. State Development Loans (SDLs): SDLs are issued by state governments. These are long-term bonds issued to raise funds for the state. SDLs pay interest every six months, while the principal is repaid on maturity. 

Benefits of investing in government bonds 

Here are some advantages of investing in government bonds:

• Government credibility: Since these bonds are issued by the central or state government, you receive regular interest payments, and the risk of default is minimal.
• Low risk and stable income: Government bonds offer a steady income stream with relatively low risk. While not entirely risk-free, they experience minimal fluctuations, which makes them a stable investment choice. 

 Risks associated with investing in government bonds 

Government bonds may carry the following risks:

• Inflation risk: Government bond interest rates are typically lower compared to other investments, which makes it challenging to keep up with inflation. However, options like capital- and inflation-indexed bonds can help protect against rising prices, as these are linked to inflation. 
• Interest rate risk: Bond prices can fluctuate with changes in interest rates. If interest rates rise, newer bonds become more attractive. This may, in turn, cause the value of existing bonds to drop, resulting in poor profits.
• Reinvestment risk: If you reinvest your bonds when interest rates are lower than when you first bought them, you may earn lower returns than expected.

How do you invest in government bonds? 

There are two ways to invest in government bonds in India:

• Investing directly   - 

You need a Demat account and a trading account to invest in government bonds directly through stock exchanges. Once these accounts are set up, you can buy and sell bonds directly through the platform. If you don’t want to open a Demat and trading account, you can simply register on the Reserve Bank of India (RBI) Retail Direct Portal and link your savings bank account to invest. 

• Investing through gilt mutual funds 

You can invest in gilt mutual funds if you prefer a professionally managed bond portfolio. These are debt funds that are exclusively invested in bonds issued by the central and state governments. Gilt funds provide an indirect way to invest in government bonds while offering benefits like professional fund management and diversification.

Conclusion

Government bonds, issued by central and state governments, can be a good option if you prefer low-risk investments. Their long-term nature makes them suitable for goals like retirement or wealth preservation. However, it is important to compare them with other investment options to understand their return potential and ability to keep up with inflation.