How do government bonds work?
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Personal Finance
- Swati Tripathi
- 2022-12-10
- 03 min read
#financial planning

What does the government do when it needs money to develop the country?

It already has the taxes we pay… but they are not enough when they have billions to invest in developmental projects, infrastructure, its corporations… the list continues.

This is where government bonds come into the picture.

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What are government bonds?

These are debt-based instruments issued by the government. By investing in government bonds, the public loans money to the government at a certain rate of interest. It is one of the most secure instruments in the market because it is government-backed, meaning that liquidity will never be an issue.

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How are they beneficial to the government?

They work to the benefit of the government as well as the public because borrowing from other governments, or the central bank puts tremendous pressure on repayment because of higher interest rates. Publicly raised funds help the government space out their payback, without any loss to the public either. Money can be raised evenly in the market instead of shouldering heavy foreign debt or imposing the entire pressure on one lender.

It ensures timely interest payments, not letting the government feel a big pinch since the annual interest amount can be divided by as many frequencies they plan to. Moreover, there is also a scope of raising a larger sum if the budget requires, without much harm to the interest plan.

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How do government bonds work?

When you buy a government bond, the government utilizes the money invested for a specific duration. It pays a pre-determined rate of interest at regular intervals, making it a fixed-income investment for the public.

On maturity, i.e., the end of the given duration, the government repays the principal amount that was initially invested.

You can invest in bonds with varied durations, ranging from five to forty years, i.e., for the long term.

In India, these debt instruments are issued by both, the Central Government as well as the State Governments. 

Catering to various purposes of both, the government and the investor, there are multiple variants of government bonds.

  1. Fixed-rate bonds
    In these bonds, the rate of interest is fixed on issuance and remains constant throughout the tenure, irrespective of the market fluctuations. This highlights it as a safe investment for the longer term.

  2. Floating rate bonds
    Floating rate bonds, on the other hand, are subject to periodic changes in the rate of interest. This change, however, is declared on the issue itself.
    Example – a bond issued in October with a declaration of 9 months, interest rates are reset every 9 months.

  3. Sovereign gold bonds
    Issued by the Central Government, these are gold-backed bonds. Investing in them would mean investing in gold without having to purchase physical gold. The prices are linked with gold prices, meaning they change as the gold market does.
    The interest earned from sovereign gold bonds is exempt from taxation. There are individual limits set for investing in gold-backed bonds and a fixed maturity for the same.

  4. Zero coupon bonds
    These do not earn interest. Investing in such a bond won’t fetch you a regular income, but a capital appreciation at maturity. Zero coupon, i.e. zero interest bonds are issued at a discount, meaning at a price lower than the face value, and redeemed at par, i.e. at face value – which covers the amount you would have received in parts by maturity.

  5. Inflation-indexed bonds
    Inflation-indexed bonds borrow their pricing from inflation. They are mainly issued for retail investors, keeping them safe from inflationary impact. This bond ensures that the interest accruing on the investment is real, changing with the market, and not rigid.

  6. Savings bonds
    These are issued at a fixed rate of 7.75% p.a., which is taxable and can be held only by Indian residents, not NRIs. They can also be held by minors with a legal representative. You need to invest a minimum of ₹1,000.

  7. Bonds with options
    This is the only bond with a right to buy back (call) and sell (put) the instruments to the issuer. The transactions take place only on the date of interest disbursal.

The good and the bad

Government bonds are a viable investment option because:

  • It ensures the stability of funds and promises consistent returns. No one has lost money investing in bonds.
  • It makes for a regular source of income.
  • It is a fantastic way of utilizing idle funds without risking them.

But these positives also make bonds disadvantageous because the returns are relatively lower than other market instruments like equity.

The last word

Investments cannot be put in black and white boxes as good or bad. Government bonds work great for those who prioritize financial security over compounding and earning more. They are also good for those without any investment experience. But if you have a good risk appetite and you envision a stronger portfolio, investing heavily in bonds is not the best choice.

The best way is to talk to a financial advisor and weigh all your options.


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