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Beginners Guide to Government Bonds in India

Co-Founder & Head of Business, Transfin.
Apr 25, 2020 1:09 PM 5 min read
Editorial

Bonds are the simplest building blocks of finance, albeit characterised by jargon-infiltrated complexity. There are no financial products more precise than the Government bond to truly illustrate Time Value of Money (TVM) – a principle on which all of finance rests. Check out RBI's FAQs (Box II), which is as good an explanation as you‘ll ever see on TVM before we jump on to bonds.

 

So what are government bonds? What is Bond Yield, Bond Price, interest rate and how can one become a bond investor? Let's dive right in!

 

 

WHAT IS A GOVERNMENT BOND?

 

A Government Bond is a Loan. Period.

Just like individuals and businesses, governments too borrow money. They need this ‘leverage’ to invest and spend on long-term projects and in turn keep the economic engine running. When governments borrow, they borrow from the central bank aka the Reserve Bank of India aka RBI. While RBI lends money to the Government, it also makes a robust financial product out of it by splitting every such loan into multiple pieces, allowing investors to participate via auctions. Voila! These pieces are called Government Bonds.

 

Anyone buying them in effect becomes a part lender to the state or said another way becomes a bond investor.

 

Government Bonds' Moving Pieces – As You’d Expect!

Just like any loan, Government bonds carry a principal, a term period and an underlying interest rate (often called a “coupon” in bond terminology). The interest rate is perhaps one of the most significant variables here, also serving as a significant monetary policy tool in hands of central bankers to calibrate inflation (but that is a detailed discussion for another day). However, it is worthwhile to know that the rate at which the central bank lends to the Government serves effectively as the “benchmark” rate.

 

All other retail lending rates for home loans, auto loans etc. are largely derived from this rate (typically by adding a risk premium on this benchmark rate)…hence making it “significant”!

 

From a bond investor’s stand-point, interest rate dictates the quantum of regular payments that investor would collect before the final principal amount at maturity.

 

What are Government Bonds?

 

But what makes bond mechanics really interesting is that they trade in public markets which opens up a whole new can of worms – from pricing and valuation to sentiment and macro indications. To get a hold of that, one needs to understand Bond Prices and Bond Yields.

 

WHAT IS BOND YIELD?

 

Bonds are characterised by something called a Yield, which is intuitively similar to the interest rate but is more nuanced. Yield is the rate of return that a bond investor generates.

 

Yield can perhaps be best understood via an illustration.

 

Say a new bond at face value of ₹1,000 is issued, offering an annual coupon of 10%.

 

Note the face value refers to the value of the bond at maturity. It is fixed on Day-1 so that the interest amount can be worked out and locked as well.

 

This means the interest earned annually would be 10% x 1,000 = ₹100 (as shown in the below table).

 

Example of how Bond Yield works.
Example of how Bond Yield works.

 

However, during the bond’s tenure it will freely trade in the public markets, which means its market price may be higher or lower than its face value (subject to supply and demand, which depends on macroeconomic drivers).

 

Now, yield is the rate of return that a bond investor generates at any given time. Say if the same bond which has a face value of ₹1,000 is trading at ₹1,200. 

 

It will be yielding = ₹100 / ₹1,200 = 8.33%. If bond price falls to ₹900, the yield will become = ₹100 / ₹900 = 11.11% .

 

Upon maturity, the yield would be ₹100 / ₹1,000 = 10% i.e. Equal to the coupon rate all along!

 

BOND PRICES & BOND YIELDS MOVE IN OPPOSITE DIRECTIONS

 

If the benchmark rate i.e. The interest rate at which the Government is borrowing the money rises (via monetary policy action by RBI to control inflation, for instance), Government bonds already owned by existing Bond investors which carry a low interest rate become become less attractive. This naturally leads to downward pressure on freely trading bond prices in order to stay competitive with these new bonds which offer higher coupon payments.

 

However, since the final principal payment and the recurring coupon payments are already locked in (assuming it is a fixed coupon rate Bond and not a floating coupon rate Bond), that has an implicit upward movement on the overall yield of the Bond while trying to converge to a yield value that is largely competitive with new bonds. This establishes the Bond price-yield inverse relationship.

 

There are so many resources on the internet which tackle Bond Price-Yield relationship in so many different ways. You may want to go on an exploratory tour yourself to get the hang of it. You need to get the intuition behind this only once in your lifetime (like swimming!!)

 

HOW TO BUY GOVERNMENT BONDS?

 

Buying Government bonds is a bit more complicated than buying equity instruments for retail investor(s). In the primary market (buying directly from issuer), the exchanges allow you to buy via a “non-competitive bidding” weekly window. Typically, Government Bonds are issued every week and a retail investor can place an order via his/her broker. The minimum amount of bidding is ₹10,000 and thereafter in multiples of ₹10,000. Your broker, in all likelihood, should have detailed steps outlined in terms of timing of these orders every week. Once you have purchased a bond, congratulations - you have now become a bond investor.

 

This bond will sit in your demat account (much like other investments) while the coupon payments will keep being credited to your linked bank account. Alternatively, exposure to government bonds can also be orchestrated via Mutual Funds!

 

The secondary market is where it gets tricky.

 

The Indian secondary market (buying from another bond investor) for Government bonds is very thinly traded and one which is perhaps best understood only by seasoned bond traders. However, for what it's worth, these resources can help you do a deeper dive and also offer some perspective on how thinly and inadequately they trade. As an FYI…trading in Government bonds by retail investors is done under “G” Group. Given the choppy liquidity associated with Government bonds, it is perhaps ideal to see them as long-term investments rather than deploy a trader mindset and hope to look for entries and exits! In the era of COVID-19, they are expected to become flights to quality.

 

Governments in general do not default. But let's say no more in that regard!

FIN.

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