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What Is A Government Bond?

IndianMoney.com Research Team | Updated On Friday, September 21,2018, 10:01 AM

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What Is A Government Bond?

 

 

A government bond is a debt instrument issued by the government of a country to finance government spending. It signifies a debt owed by the government to the holder of the bond. In simple language, a bond is a loan taken by the government, on which it pays interest. This loan matures after a fixed period of time, at which point, the government redeems the bond by paying back the principal amount. Depending upon the type of government bonds, the tenure is between 91 days to 40 years.

Any individual, Non-Resident Indian (NRI), Hindu Undivided Family (HUF) or institution can buy these bonds from the government. Bonds are issued at a minimum face value of Rs 1,000 and in multiples thereof and there is no maximum limit for investing in government bonds. Government bonds are sold by the Reserve Bank of India (RBI) on behalf of the government.

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What Is A Government Bond?

Bonds can be classified into three broad categories based on their price.

Standard Bond – Standard bonds are issued and traded at their par value or face value. The existing price of these bonds is neither above nor below their face value.

Premium Bond – When a bond is issued at a price higher than its face value, it is known as a premium bond. Any bond that is trading in the secondary market at a price higher than par value is also a premium bond.

Discount Bond – Sometimes, bonds are issued at a value less than their face value, or traded in the secondary market at less than their face value. These types of bonds are known as Discount Bonds.

Terms related to Government Bonds

  1. G-Security (G-Sec) – Government securities are debt instruments issued by the central or state government acknowledging a debt owed by them.
  2. Coupon Rate – It is the annual rate of interest that a holder receives. It is calculated as a percentage of the Par value/Face value. If the coupon date, i.e. the date of interest payment falls on a Sunday or holiday, the payment will be made on the following working day.
  3. Zero Coupon Bonds–These bonds do not carry any interest payment. These bonds are issued at a deep discount and then redeemed at face value upon maturity.
  4. Yield To Maturity (YTM)–YTM is the total anticipated return from the bond if it is held till maturity, which is expressed as an annual rate. It takes into account the time value of the periodical returns by discounting them to the present value.
  5. Tenure–Tenure is the period of time for which a bond is valid. It is the time between issue and maturity. Bonds have tenures varying from less than 91 days to 40 years and more.
  6. Maturity – Maturity is the date on which the bond will be redeemed. The date of principal repayment is Maturity. In case the maturity falls on a Sunday or holiday, the redemption takes place on the preceding working day.
  7. Par Value – It refers to the face value of the bond. The original price of the bond before any discount or premium.
  8. Duration – It measures how long it takes in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

Types of Government Securities

1. Treasury Bills (T-Bills)

Treasury Bills, also known as T-Bills are money market instruments that are issued for the short term. They are of 91 days, 182 days and 364 days.

2. Cash Management Bills (CMBs)

CMBs have the shortest tenure of all government bonds, less than 91 days. These are issued to meet the temporary deficits in cash.

3. Dated Government Securities

Dated G-Secs are long term securities that carry either a fixed or floating coupon rate which is payable at fixed time intervals. Dated G-Secs are further classified into the following types:

  • Fixed Rate Bonds

A majority of the G-Secs are fixed rate bonds. The interest rate for these bonds are fixed for the life of the bond.

  • Floating Rate Bonds

Floating rate bonds have no fixed rate of interest. The coupon rate is revised at pre-announced intervals. This rate changes throughout the life of the bond.

  • Zero Coupon Bonds

Zero coupon bonds have no interest rate and therefore no interest payment. They are issued at a discount and redeemed at par.

  • Capital Index Bonds

These are bonds that have their principal linked to an accepted index of inflation with a view to protect the principal of the investor from inflation.

  • Inflation Indexed Bonds (IIBs)

IIBs are bonds which have coupon flows as well as principal amount linked to an inflation index like Consumer Price Index (CPI). It provides the investor with a constant level of return irrespective of the inflation in the economy.

  • Bonds with Call/Put option

These bonds come with an option for redemption before maturity. The issuer has the option to buyback (call) and the investor has the option to sell (put) it back to the issuer at face value. The option can be exercised by the investor or issuer only after 5 years from the issue date of the bond on any of the coupon dates.

  • Special Securities

Special securities are sometimes issued by the government to corporations in lieu of cash subsidies. The companies raise funds by divesting these bonds in the secondary market to banks, insurance companies and so on.

  • STRIPS

Separate Trading of Registered Interest and Principal of Securities. Each cash flow of a fixed rate bond is converted into individual securities and traded in the secondary market. They are similar to zero coupon bonds except that they are created out of existing securities.

  • Sovereign Gold Bonds

Sovereign Gold Bonds have their prices linked to commodity price like gold. The price of the bond at the time of issue and redemption are calculated based on previous week’s simple average of closing price of gold of 999 purity as published by India Bullion and Jewellers Association Ltd (IBJA).

4. State Development Loans (SDLs)

State Development Loans are issued by the State Government to raise loans from the public. Interest is paid at regular intervals and principal is paid at maturity.

How to Invest In Government Securities?

G-Secs are issued through auctions conducted by RBI, in consultation with the government. The RBI issues a half yearly auction calendar which contains information on the borrowing amount, tenure and likely auction dates. A press release with exact details on the securities and the procedure of the auction is issued by the government a week before the actual dates of the auction.

Auctions are conducted by the RBI on the electronic platform, called the e-Kuber. Commercial banks, Scheduled Non-cooperative banks, provident funds, insurance companies who have a securities account with RBI are members of this electronic platform. All non-members can participate in the auction by opening a securities account (also known as Gilt Account) with a bank or Primary Member.

Government Bonds are considered a fixed income, risk free investment as they are issued by the government which doesn’t usually default on payments. G-Secs can be liquidated very quickly by selling them in the secondary market. They can also be used as collateral for borrowing.

SEE ALSO: Unsecured Loan

Bond Price and Interest Rate

Bond prices are inversely related to the interest rates. This means that when the interest rates rise, the price of the bond falls and vice versa. This may seem illogical at first, but upon looking at it closer, it makes sense. Let us try to understand with the help of an example.

A bond with a face value of Rs 1,000 and coupon of 5% is currently trading at Rs 950. If the interest rates rise to 6% for the newly issued bonds, the current price of the bond would be out of demand as there is a new bond that gives higher yield. Investors naturally look to maximise their returns for a given level of investment or minimize their investment for a given level of returns. Therefore, for the yield to match the new interest rate of 6%, the price of the bond must fall.

Masala Bonds

Masala Bonds was a term coined by the International Finance Corporation (IFC) to represent the bonds issued outside India, but in Indian denominations (Rupees). The bonds are pegged directly to the Indian Rupee so that any losses as a result of a fall in the rupee will be borne by the investor and not the issuer, which is usually an Indian corporation operating overseas. Masala Bonds are issued to fund infrastructure projects, internal growth and internationalise Indian Currency. If a foreign investor actively invests in Masala Bonds, it brings in money to India which will strengthen the Indian Rupee. The first Masala Bonds were issued by the World Bank in November 2014, and in July 2016, HDFC became the first Indian company to issue Masala Bonds when it raised Rs 3,000 crores from the bonds.

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