Investors hear a lot about how debt is safer than equity (or in other words, how bonds are safer than equity) but at the same time, they hear about default risk on the part of the bond issuer. How can bonds be safe when it is possible that the company will not repay your capital? Some brands even come with a fluctuating rate of interest and others promise ascending interest, but also retain the right to remove the deal from the table at any point.
But there’s no smoke without a fire, as the saying goes. Where then, is the proverbial fire; the basis of these claims; the bonds that are safe and represent a fixed income?
Well, in all probability, bonds earned themselves such a good name all thanks to Savings Bonds.
What is a savings bond?
A savings bond is a government-issued bond where the investor is promised 7.75% interest per annum, paid out biannually, as well as a return of his capital by the predetermined maturity date.
The shiny, attractive feature of savings bonds is that they come with a sovereign guarantee or a guarantee that the government will pay bondholders back.
Why the government issues savings bonds:
Every ministry of the government and every city’s municipality, too, functions like a company. They have income (earned through the likes of taxes and tolls) and they have expenditure. Most often, expenditure is equal to, or in excess of income. With this background, how do public logistical projects such as sea links and highways get funded? The government needs to attract funding from the public and it does so via savings bonds.
Benefits of savings bonds
The sovereign guarantee that backs savings bonds eliminates all default risk. Investors can rest easy knowing that the government will not run off with their money. The main risk that any investor fears is the potential for capital loss and therefore a guarantee that capital will be returned is a hugely attractive factor for many investors.
Bonds can be sold in the stock market prior to maturity if the investor finds himself needing to divert the capital that he invested in the bond, elsewhere. This means that the investor need not wait till maturity and can sell the bond and get back his capital, provided of course the market conditions are right.
Good option for seniors
Being low-risk, savings bonds are a good option for senior citizens. The lock-in period goes down to 5 years at age 70 and to 4 years for investors who are 80 years old and above. It becomes competitive with any term deposits but also retains the potential of being sold during a peak in its stock market pricing.
No upper limit
Investors can park any amount of capital in savings bonds. There are no caps as one might have experienced when buying sovereign gold bonds, for example. This means that investors can really invest a large amount to experience multiplier effect and sizable interest.
Investors can enjoy a regular biannual income from their savings bonds. Imagine a senior who has amassed a good amount of savings by his retirement (or anyone else who has managed go save) and manages to put even as little as Rs 5 lakh in savings bonds.
At 7.75% interest, one’s interest earnings would come to Rs 38,750 – an amount that the investor receives biannually.
If you have no need for capital right now but are saving towards a certain financial goal, you can opt for cumulative interest payment and GST back your capital plus the interest, as a lump sum.
Alternatively, you can opt for the typical biannual payout that most investors opt for.
Considerations when investing in savings bonds
Savings bonds call for a commitment of 7 years which might be a challenge for the biggest chunk of the investor population, namely millennials, who cannot even commit to smartphones and laptops for as much as a year. Gratification might be too delayed for some investors.
Risky if traded
One might argue that liquidity can be obtained by selling the bond on the stock market, but as we discussed even in the benefits of savings bonds, one needs to wait for the price of the bond to be higher than what they paid for it to avoid losses (and higher than the amount they would have received with interest if they intend to exit with comparable earnings). Moreover, selling a bond on the stock market means exposing oneself to stock market risk and also calls for some understanding of stock market basics.
Interest is taxable
Of course, the tax is only a fraction of the interest, but investors should do the math to get a firm picture of what they would be earning.
Comparable income from other investments
Compare what you would be earning from your savings bond to other fixed income investments that offer a similar level of capital safety and interest but shorter maturity terms to be sure that it is indeed the best option you have in hand.
Savings bonds are an attractive low-risk investment option that can be used to diversify a portfolio, hedge risk or have a reliable and safe income source, especially after retirement. Investors should ensure they are up for the 7 year lock in period if they want to avoid having to trade the bond on the open market prior to maturity.