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Thursday, February 25, 2021

Indian government bonds for retail investors: Why is this a great move.

RBI's decision to allow direct retail investors to buy government bonds could be a game changer. Will this impact existing banking inflows?

India became the third country in the world after USA, Brazil to let retail investors buy its government bonds. This is a big deal and a game changer. RBI Governor Shaktikanta Das called this as a “major structural reform”.

What are government bonds?

Investopedia defines Government bonds as the bonds issued by governments to raise money to finance projects or day-to-day operations. In the USA, the Treasury Department issues the bonds through auctions through out the year. Once the banks purchase the bonds in the primary market, retail investors can buy and sell them in the secondary market like corporate stocks. Unlike USA’s Federal Reserve Board (FRB), India’s RBI acts as both a currency issuing agency and a regulatory agency. In USA, FRB only acts as a regulatory agency and the Treasury Department issues the currency.

How are the bond prices determined?

Like any trading instrument, government bonds too carry an investment risk. In this case its called interest rate risk because of the potential for bond face value fluctuations due to the underlying change of the base interest.  In the world of bond market, US Treasury bonds are considered zero risk instruments because of various zero risk factors including zero country risk, zero political risk, and zero central bank risk. In other words, come what may, investors see the US institutions as the most stable institutions in the world. Compared to US bonds, investors perceive bonds such as Indian government bonds as more risky.

Why a open bond market in India is a welcome move?

During her budget speech, Finance minister Nirmala Sitaraman announced India’s fiscal deficit settled at 9.5% in 2020-21 and will be targeted at 6.8% in 2021-22. And during this fiscal year, India is expected to borrow approximately 12 trillion rupees to meet the budget shortfall. Opening the bond market to India’s retail investors will help to raise this money at a cheaper price when compared to borrowing money while selling its sovereign bonds in the international market.  The interest India has to pay to foreign investors who buy its sovereign bonds is based on its credit rating. As of Feb 2021, Standard & Poor’s credit rating for India stands at BBB- with stable outlook. However, Moody’s credit rating for India was last set at Baa3 with negative outlook.

India Credit Rating for bond market
Snapshot of government debt credit rating for India as reported by major credit rating agencies. Taken from Trading Economics. 

This poor rating and negative outlook makes India’s borrowing expensive in the international markets. This is where India’s domestic investors can come in handy. A positive sentiment arising on the economic growth from with in the country can reduce the borrowing costs for the government of India. Additionally this move also widens the investor base for Indian bonds without compromising on existing policies.

How can the retail investors invest in Indian government bonds?

Retail investors will be allowed to open a gilt account and be given access to RBI’s platform called “E-Kuber”. Like any other capital markets investment instrument, investors can place a bid with an RBI owned electronic anonymous order matching system called “NDS-OM”. So far, the “NDS-OM” allowed membership from institutional investors including banks and insurance companies.

How can the investment in Indian bond market help individual investors?

An investment in Government issued bonds will allow retail investors to optimize the overall risk of their investment portfolio. In a typical situation, investors distribute their investments among mutual funds, individual stocks, real estate and fixed income deposits. The inclusion of government bonds will open a new avenue to further spread their investment risk in their portfolio. Learnings from the US indicate an interest on a government issued bond will be higher than what banks can offer. This means increased interest income for individual investors while potentially reducing the risk exposure.

Mortgage Rates vs. Treasury Yields
An example of bank interest rates (e.g. mortgages) vs. Treasury Yields. Picture Credit: The Balance.

According to the RBI’s governor, this does not mean less inflows into the banking system.

“It will not undermine the flow of deposits for banks and mutual funds. Even today, small savings rates offer higher rates than bank deposits, but still substantial money flows into bank deposits,” he said.

As government plans to sell its stake in various public enterprises (e.g. LIC), to raise 1.75 trillion rupees, the money it can raise, this option of raising money can prove to be a cheaper and more acceptable form of growing its fiscal deficit.

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