Sovereign Gold Bonds: End of an Era?

Back in November 2015, Prime Minister Narendra Modi launched the sovereign gold bonds scheme.

The idea was simple. Investors could meet their demand for gold without actually buying it. This would reduce India's gold imports. The government would also get to borrow money at a low interest rate.

Sovereign gold bonds (SGB) were debt instruments. They were issued by the Reserve Bank of India (RBI) on behalf of the government. It was an alternative to buying physical gold.

The units of SGBs were denominated in gold, starting from 1 gm and then in multiples thereof up to a maximum of 4 kg. The bonds had a maturity period of 8 years with exit options after 5 years. They were tradeable on the stock exchanges.

The bonds paid a modest semi-annual interest rate of 2.5% or 2.75%. On maturity, the government would repay the amount that the bonds were worth based on the prevailing gold price.

Thus, investors had a viable alternative to holding gold. They could hold SGBs instead and earn interest on it. While the interest was taxable, capital gains on the final redemption amount was not.

The best part was the sovereign guarantee given to the SGBs. This made the SGBs very popular.

Whenever the RBI would issue a tranche of these bonds, a few times each year, they would sell out quickly. To date, the RBI has sold 147 million units of SGBs in 67 tranches.

This was a good deal for the government as well because the interest rate of 2.5-2.75% was vastly lower than the interest payable on the 10-year benchmark government bond.

The only uncertainty with SGBs was the price of gold. This would determine the price of the bond. This was a risk that would have to be considered by both the investors and the government.

If the price of gold went up over the 8-year period, then the government would have to shell out the difference. If the price fell, the investors would bear the loss.

The Situation Now

Well, as we all know the price of gold has soared since 2015. Internationally, the gold price has gone up from US$ 1,100 per troy ounce to US$ 2,500 today.

However, due to the depreciation of the Indian rupee against the US dollar, the gains in the domestic market has been higher. This has negated the benefits of the lower interest rate.

The SGB tranches that are nearing maturity have delivered a return of 9-11% as per a report on Moneycontrol. This is on top of the 2.5% annual interest. The capital gains will be tax free and there is a sovereign guarantee on the repayment.

Also, the price of gold is showing no signs of slowing down. The higher it rises the bigger will be the cost for the government in the future.

Thus, there have been rumours that the government could drastically scale down the issuance of these bonds going forward or might even consider scrapping the scheme entirely.

The last tranche of SGBs were issued in February this year. Following the reduction of customs duty on gold and silver from 15% to 6% in the Union Budget 2024, the likelihood of new SGB issuances has decreased. At present there is no clarity about the future issuances.

This has triggered interest in the SGBs with the highest liquidity in the market. Investors are looking to buy as many SGBs as possible at a reasonable price, even if it's at a premium, before the government announces a reduction or discontinuation of the scheme.

Thus, some SGBs are trading at premium to the physical gold price up to 8% at the time of writing.

Clearly, the investors who consider SGBs as an alternative to physical gold and to potentially profit from the rising gold price, are willing to pay a premium for the listed SGBs on the market.

Conclusion

The popularity of the sovereign gold bonds might have been its undoing.

Due to the run up in gold prices, SGB investors have enjoyed about double digit total annual returns (interest + capital gains) with a sovereign guarantee.

Add to that the tax free capital gains on maturity, and you can see why the government may not be keen on continuing the scheme. The cost has proven to be high.

On the other hand, investors have enjoyed about double digit tax free capital gains on their investment, over a period of 8 years, with a sovereign guarantee. This kind of 'risk free' returns is near impossible to achieve in almost any other investment.

To be clear, there was risk involved, i.e., the price risk of gold. But as the gold price has moved up consistently since the first tranche was launched, the risk has been the government's to bear.

Even if SGBs become a thing of the past, we at Equitymaster have always suggested, holding at least 5-10% of one's total investments in gold.

It makes sense to hold some gold in one's long-term portfolio, but it doesn't make sense to speculate on short term price movements.

If you're interested in adding gold to your investment portfolio, this editorial will be helpful: How to Invest in Gold in India.

If you want to invest via in an electronic format do read this article: How to Invest in Digital Gold.

Happy investing.

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