In its latest monetary policy, the Reserve Bank of India has allowed direct retail participation in the government or treasury bonds. Retail or individual investors can now open a gilt account on the RBI's electronic trading platform and bid for the bond in the auctions. The gilt account can be used to buy and sell government bonds in the same manner as we trade stocks on our online trading accounts.
The latest move by the RBI is part of a long-term strategy to improve retail participation in the government bond market. Right now, the bulk of the government or treasury bonds are bought by institutional investors such as banks, insurance companies and debt mutual funds. So retail investors currently invest in government bonds indirectly.
The government has its own reason to popularise bond investing among retail investors given India’s record high national debt and government ambitious borrowing programme.
Here are some things to keep in mind if you are planning to make direct investment in government bonds.
1. Government bonds are fixed income instruments like bank and post office fixed deposits, corporate deposits and bond mutual funds. You can invest in them if the interest rate or yield is higher than those offered by banks and post-office FDs. Right now, the yield on a 10-year government of India bond is 6.1 per cent, which is not very different from the interest on bank FDs and a little lower than the interest on post office deposits.
2. The state government bonds, also called SDL or State Development Bonds, offer higher yields. In the latest round of auction, yields on SDL were as high as 7 per cent on average, nearly 90 basis points higher than central government bonds. This is higher than the current FD rates offered by banks or post office deposits. Only corporate deposits and non-convertible debentures (NCDs) offer higher rates.
This makes state government bonds a great option for investors looking for higher yields but are too risk averse to invest in corporate deposits or NCDs.
3. Investing in government bonds, however, works differently from other fixed income instruments. While the interest rate on bank or post office deposits is locked in for the entire tenure and is fixed, the effective interest rate or yield on government bonds can vary a lot depending on the purchase price of the bond.
The final price at which the bonds will be fully subscribed by investors can be different from the RBI offered price or the par value. This, in turn, affects the effective yield that an investor earns on his investment.
For example, say RBI offers 10-year government bonds with 6 percent interest for a par value of Rs 100 each. If during the auction, most of the bids come at Rs 110/bond, then the effective yield or the interest rate becomes 5.45 per cent (6/110). Alternatively, if most of the bids come at Rs 90/bond, then the effective yield for investors becomes 6.66 per cent (6/90).
4. Bonds are listed and traded on exchanges just like stocks.
The fluctuation in bond prices is however significantly lower than stocks and is determined by changes in investors' expectations about the interest rates.
Government bonds are however much safer than stocks as their price will never fall to zero unlike stock prices. The only risk that bond investors take is the interest rate risk. If the interest rate rises after you have invested then the bond price will fall and if the interest rate declines then bond prices rally. To put it differently, you can treat a bond as a stock that offers a fixed rate of dividend and the stock price rises and falls depending on the dividend offered by new stocks that are listed subsequently.
5. Bond trading can be as profitable as trading in stocks or commodities provided you have the necessary skills and aptitude. The most important requirement for a bond trader or investors is the ability to predict the interest rate cycle.
Conversely, if the interest rate rises post your investment then you may have to book losses. Given this, investment in bonds requires a different skill set than equity investing. This besides other reasons limits retail participation in bonds.
(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).