With gold prices swirling down daily for over a month and prices of goods increasing under the impact of inflation, many people are looking to park their funds in Sovereign Gold Bonds (SGBs) referred to as paper substitutes for holding physical gold.
As opposed to the difficulties in storing and securing gold coins or ingots in lockers and vaults, you can keep the SGB document anywhere in your home. Since the SGB document comes in a digital format, you can always seek a copy of the document, from the nearest bank by submitting your PAN Card or Aadhaar number, if you lose it.
Many investors are unsure of the effectiveness of SGBs and are keen to know if they lose value over time. Also, many want to know if there are chances of losing their principal in a bond backed by a sovereign guarantee. Questions such as these and many more are gaining precedence over other investment options as gold continues to lose its shine and sheen over its deteriorating value in the market.
To understand the risks posed by investors about SGBs issued by the Reserve Bank of India (RBI), we must first understand what “sovereign guarantee” means and its implications for investors.
Firstly, SGBs are not like the other bonds issued by the government. They are different in the sense that the central government guarantees investors a fixed rate of 2.50 per cent every year payable semi-annually on the nominal value.
Investors would avail of this interest amount till the date of redemption of the bonds. The redemption value would be equal to the average of the gold prices during the three days before redemption. The interest amount is an incentive to encourage investors to invest more in these bonds. This is different from the interest guaranteed on other bonds issued by the Indian government.
Government bonds are different. Take, for example, you buy a bond that would mature after 10 years. The government promises to pay you the interest on the bond two times each year till the date of maturity. The government will redeem you the bond price post-completion of the tenure or during the buyback of the bonds before maturity. The government would rarely default on paying you the interest amount or on repaying the bond amount on maturity.
If everything looks so good on the outside, does it mean that there are no risks involved in investing in SGBs? True that there may be a risk in terms of capital loss if the price of gold declines.
Rahul Agarwal, Proprietor, Advent Financial says, “The redemption amount in an SGB is linked to the price of physical gold and therefore if the price of gold at the time of maturity is lesser than the allotment price, investors are exposed to capital risk. Additionally, because these bonds have a long tenor of 8 years, investors could also be exposed to liquidity risks due to lack of trading volumes.”
However, investors have not witnessed or experienced a capital loss on their gold investments. Compared to this, fluctuations in long-term gilt or RBI bonds are common. This is especially true for long-tenured bonds that are more subject to fluctuations.
Muthukrishnan, a Chennai-based Certified Financial Planner says, “Bond prices and interest rates are related. When the interest rate goes up, bond prices fall. When the interest rate goes down, bond prices gain. Long-term bonds have a greater duration than short-term bonds. Short-term bonds are closer to maturity and have only a few coupon payments left. Hence, they are less volatile. Long-term bonds are farther to maturity and have many coupon payments left. That's why they’re more volatile.”
Prathiba Girish, Founder, Finwise Personal Finance Solutions says, “Long-term bonds have greater duration. The price of bonds is inversely proportional to the interest rates in a rising rate scenario the price of the bonds goes down with every increase in the interest rate and vice versa. This is because the price of a bond is the present value of all future cash flows In short-term bonds since time frames are limited the present value is not vastly different hence they are less volatile.”
If you sell your government bonds or SGBs before maturity, there is always a chance of capital loss in both.
Relying on gold price movement
Many investors think that gold prices always move up in the long run. Their understanding of gold investments is backed by data suggesting how gold has delivered over 54000 per cent returns to its investors since the country’s independence.
Though the prices of the metal tend to slump temporarily, its rise over the period coupled with the bi-annual interest has given enough reason for them to park their money in them. Unlike stocks that slumped and lost their value for a short period post-pandemic and sporadic market crashes, gold prices have steadily gone up.
A primary example of this is how gold prices continued their upward trend post the 2008 global economic slowdown. Other than equities, investments in bonds have also been under scrutiny considering how the government may fail to deliver on its promise.
Should you buy SGBs?
Know that SGBs are unlike gold mutual funds that you may redeem within a year. Buy SGBs only when you are ready to stay invested in them for the entire period. Gold is deemed a perfect hedge against inflation; however, it may not be ideal if you are buying it for portfolio diversification.
This is because you cannot buy or sell SGBs at your convenience. If you wish to adopt a tactical strategy, investing in gold funds or gold ETFs is better. Buy SGBs only if you are willing to buy and hold. It is then that SGBs are completely risk-free.