Government Securities: Meaning, Types, Advantages and Disadvantages

In this chapter, we’ll look at what government securities are, and different types and also learn how you can invest in such investment instruments. 

Introduction 

Government securities, often called “G-Secs”, are debt instruments the central and state governments issue to raise funds for various purposes like financing infrastructure projects, bridging budgetary gaps or managing national debts. They play a pivotal role in a country's economy and stock markets.

G-Sec guarantees the complete repayment of the invested principal amount upon the security's maturity, along with periodic coupon or interest payments in some instances. Their functioning is similar to corporate debt issues. Hence, sovereign gold bonds issued by the Reserve Bank of India (RBI) are a classic example of government securities.

Types of Government Securities in India

Here are some key types of government securities issued in India:

Treasury Bills (T-Bills)  

Treasury bills or T-Bills are short-term debt instruments issued by the government of India, typically maturing in a few days to one year. They are issued at a discount to face value and do not pay any periodic interest.

For example, a 91-day T-Bill with a face value of ₹100 may be issued to investors at ₹ 97. After 91 days, the investor receives ₹100, earning a return of ₹3 or around 12% annualised.

Treasury Notes (T-Notes)

Treasury Notes or T-Notes are medium-term Government securities, typically with original maturities between two to ten years. Unlike T-Bills, T-Notes pay investors a fixed interest rate (coupon) every six months. 

For instance, a T-Note offering 7% annual interest will pay 3.5% of the face value as a coupon every six months. These are popular among investors seeking relatively safe fixed-income products.

Treasury Bonds (T-Bonds) 

Also referred to as T-Bonds, these are long-term Government debt instruments with original maturities exceeding ten years, often up to 30 years. Like T-Notes, these bonds also offer fixed semi-annual coupon payments to investors.

Cash Management Bills (CMBs)  

Cash Management Bills or CMBs are short-term Government securities issued on an as-needed basis to meet the immediate cash requirements of the Government. They generally have maturities of less than 91 days.

State Development Loans  

State Governments issue State Development Loans or SDLs to raise funds for financing development projects and managing other funding needs. These bonds have varying maturities and interest rates depending on the financial health of the issuing state.

Zero-Coupon Bonds

As the name suggests, Zero-Coupon Bonds do not offer periodic interest payments, unlike regular bonds. Instead, they are issued at a significant discount to face value, representing the interest component. The investor receives the entire face value on maturity.

Capital Indexed Bonds  

The principal amount of Capital Indexed Bonds changes based on inflation indexes, ensuring the investment's real value is protected from inflation. This makes them especially attractive during periods of rising inflation.

Savings Bonds

Savings Bonds are retail products targeted at individual investors promising fixed interest rates and relative capital safety. They cater to conservative investors looking for stable and predictable investment returns.

Functioning of Government Securities

Government securities enable governments to raise funds from investors against a promise of repayments upon maturity and periodic interest as applicable. By purchasing these securities, investors effectively lend funds to the government in return for interest income and principal repayment.

The fundamental appeal of G-Secs stems from their perceived safety, backed by the creditworthiness of the issuing government. As a result, they offer lower yields compared to riskier private investments. Conservative investors often use G-Secs to balance the risk-return profile of investment portfolios. Grasping the functioning of these instruments is vital for understanding financial markets.

Eligibility to Purchase Government Securities

A diverse range of entities can invest in G-Secs, including banks, insurance companies, mutual funds, provident funds, corporate bodies, high net-worth individuals (HNIs), regional rural banks, cooperative banks, etc. Even foreign institutional investors (FIIs) and non-resident Indians (NRIs) can invest within certain limits.

G-Secs are issued via regular auctions conducted by the RBI, where eligible entities can submit competitive bids. Confident retail investors can access select G-Secs through authorized brokers and online channels. Understanding the ecosystem and nuances involved is crucial before investing in this asset class.

Secondary Market Trading 

The robust secondary market furthers the appeal of G-Secs. Following initial issuances through RBI auctions, these securities get listed and actively traded on major stock exchanges. Market participants can conveniently buy and sell listed G-Secs at prevailing market rates on the exchanges. This imparts liquidity into the system.

The aggregating turnover in the secondary G-Secs market has surged rapidly from ₹1.8 lakh crore in 2000-01 to over ₹135 lakh crore in 2021-22. Strengthening secondary market activity has enhanced the overall depth of Indian debt markets. It has also bolstered the role of G-Secs as collateral for trading and lending activities among banks and financial institutions.

Advantages of Investing in G-Secs

Investing a share of your investible capital into G-Secs as part of a diversified portfolio carries multiple benefits, such as:

1. Low risk: G-Secs are sovereign guaranteed, implying that they are one of the safest domestic investment options. This investment provides timely interest payment and principal redemption irrespective of the market situation.
2. Steady returns: G-Secs offer lower returns, though, compared to the equities. However, G-secs are not as volatile as equities, so they offer stable fixed returns. 
3. Wealth preservation: G-Sec returns are a stabilising factor that mitigates the portfolio risks from investments in other risky assets. This means that the higher the allocation towards G-secs, the lower the volatility. Therefore, G-secs are good instruments for Individuals looking to preserve wealth rather than create wealth. 
4. Liquidity: Actively traded G-Secs give the investor a convenient exit route via sale in the secondary market. The liquidity of T-bills and dated securities is especially high due to the constant buying and selling by large institutions. 
5. Low credit risk: G-Secs backed by the government have no default risk, resulting in virtually zero credit risk. However, do note that this depends upon historical interest payments made by the country. Since the Indian government has never defaulted in history, they are considered virtually risk-free but there are instances where a country’s government ran out of money and could not pay their interest payments on time. 

Drawbacks of Investing in G-Secs

However, G-Secs also carry certain limitations that investors should acknowledge:

1. Interest Rate Risks: There is an inverse relationship between bond prices and the level of interest rates. Upward rates may cause interim capital loss for current bondholders until maturity.
2. Inflation Risks: When an investment horizon is long, inflation causes the erosion of the purchasing power and real returns from fixed-income instruments such as G-Secs.
3. Lower returns: The sovereign guarantee by a country results in lower coupon rates on G-Secs compared to higher-yielding corporate bonds.
4. Taxation: Interest income from G-Secs is subject to tax as per the investor's applicable tax slab, similar to how dividends may be treated in equities. 

Given the above, conservative investors seeking capital preservation may allocate some portion of their debt portfolio to high-quality G-Secs while balancing overall risks suitably. Those willing to accept some risks could diversify across higher-yielding corporate bonds.

Key Drivers of the Government Securities Market

As integral components, G-Sec yields and prices react swiftly to changing financial and economic conditions. Below are some influential drivers:

1. Monetary Policy: Interventions of RBI in moderating money supply, interest rates, and liquidity affect yields and valuations. As an example, tightening of monetary policy leads to an increase in the interest rate and the cost of money due to which G-Sec yields go up.
2. Inflation - Interest Rate Outlook: Investors’ expectations on the likely interest rate trajectory going forward are based on current inflation readings and future projections. This impacts investment strategy.
3. Macroeconomic Factors: Major parameters such as GDP growth projections, fiscal deficit, trade deficit and currency fluctuations determine the bond market outlook. For example, greater fiscal deficits, which lead to increased borrowings, make G-Sec yields go up.
4. Oil Prices: Being one of the major importers, growing world crude prices, which result in high trade deficits, have the tendency to dampen demand for bonds from investors.
5. Global Factors: Overseas developments, such as bond yields and policies of major central banks, have consequences on domestic markets and the risk appetite of the investors.
6. Liquidity Conditions: Systemic liquidity is generous, and therefore, demand for G-Secs is usually sustained. Narrow liquidity makes the availability of funds complex and tends to quench market hunger.

Investing in Government Securities 

Retail investors keen on investing in G-Secs can access certain government-dated securities and T-Bills via the following channels:

• Non-Competitive Bidding

Retail investors can directly participate in select primary auctions for T-Bills 91 Days, 182 Days and 364 Days through authorised brokers and online platforms via the non-competitive bidding route. Here, participants agree to accept the cut-off yield set through competitive bidding.

• Negotiated Dealing System-Order Matching (NDS OM)

T-Bills and dated G-Secs are available to retail investors on a daily basis through approved brokers on NDS-OM, a screen-based anonymous electronic order matching system for trading G-Secs owned by the Clearing Corporation of India.

• Stock Exchanges

Select government securities get listed on major exchanges following initial issuances, allowing retail investors to conveniently buy/sell them on the secondary market at prevailing prices.

Apart from the above, high net worth individuals (HNIs) can participate directly along with institutions through competitive bidding upon fulfilling eligibility criteria set by the RBI.

Understanding applicable regulations and associated processes is vital before transacting in G-Secs. Investors must also evaluate factors like preferred investment horizon, liquidity needs, risk appetite, tax implications, etc., while deciding on suitable G-Sec exposure.

Taxation Framework for Government Securities 

The taxation structure applicable to income generated from investing in G-Secs is as follows:  

• Interest Income

The semi-annual coupon payments received are classified as 'Income from Other Sources' and taxed as per the investor's income tax slab rates.

• Capital Gains

Profits booked from selling G-Secs in the secondary market before maturity are categorised under 'Capital Gains' and taxed accordingly. If sold within 12 months, short-term capital gains (STCG) tax rates apply. Otherwise, long-term capital gains (LTCG) rates apply if held for over 12 months.

Indexation benefits allowing adjustments for inflation during the holding period are available on LTCG arising from debt investments. Specific categories of investors, such as insurance companies, pension funds, charitable organisations, etc., avail exemptions.

Limitations of Investing in Government Securities 

While G-Secs merit inclusion in diversified investment portfolios given their sovereign backing, investors should acknowledge certain limitations:

1. Market Risks: Despite strong fundamentals, intermittent volatility in G-Sec prices linked to evolving macroeconomic conditions can lead to mark-to-market losses. However, most retail investors follow a buy-and-hold strategy till maturity, limiting impact.
2. Moderate Yields: Relative safety comes at the expense of marginally lower returns vis-a-vis higher-rated corporate bonds across comparable investment tenures.
3. Reinvestment Risk: Investors may need help finding bonds offering similar or better yields at times, thereby impacting overall returns.
4. Opportunity Costs: Committing large capital to G-Secs entails reduced capacity for potentially higher returning avenues like equities.

In light of the above, astute asset allocation calibrating overall portfolio risks and returns becomes critical while considering investments in G-Secs.

Government Securities versus Other Major Asset Classes 

The following comparative analysis highlights how G-Secs fare relative to other key investment alternatives on significant parameters:

Parameters	Returns	Income Frequency	Risk Profile	Inflation Risks	Liquidity	Issuer Risks	Taxation
Government Securities	Moderate	Half Yearly Coupons	Minimal	Subject to Some Extent	Very Liquid	Negligible - Sovereign Backed	Tax as per Applicable Rates
Equities	Highest Potential	Dividends as declared	Highest	Partly Provides Inflation Hedge	Liquid	Company Performance Dependent	Tax as per Applicable Rates
Corporate Bonds	Moderate	Regular Coupons	Low to Moderate	Subject to Some Extent	Relatively Illiquid	Depends on Credit Rating	Tax as per Applicable Rates
Mutual Funds	Market Linked	Dividends or NAV Gains	Based on Asset Mix	Based on Asset Mix	Very Liquid	Market Contingent	Tax as per Applicable Rates
Real Estate	Stable Income + Capital Appreciation	Rental as per Contract	Moderate	Provides Partial Hedge	Illiquid Asset Class	Counterparty Dependent	Tax as per Applicable Rates

Government Securities thus emerge as fixed-income products balancing stability and income generation for debt investors, while corporate equities represent growth avenues for equity investors. Even real estate offers tangible benefits. Asset allocation needs to be customised to specific investor risk profiles and preferences.

Conclusion

Government securities represent integral components of well-diversified investment portfolios while fulfilling crucial systemic functions in developing robust financial markets. 

They balance stability, safety and liquidity for investors seeking options beyond traditional fixed deposits. With recent regulatory efforts towards enhancing retail participation, both awareness and accessibility of G-Secs will likely expand. Investors across risk appetites stand to benefit by harnessing the versatile attributes of these sovereign-backed instruments towards achieving their strategic investment goals.