Should you buy sovereign gold bonds in the secondary market?

29 Oct 2024 , 02:59 PM

HOW SOVEREIGN GOLD BONDS BECAME SO IMMENSELY POPULAR?

One of the products that had become extremely popular in the last few years is the Sovereign Gold Bonds (SGB). These are bonds issued by the central government through the RBI, that are pegged to the price of gold. In the last 5-7 years, the price of gold has more than doubled and that has means phenomenal gains for investors in these sovereign gold bonds. Gold has always been an asset class that has intrigued and interested Indian investors. With an increasing number of Indian investors looking at gold as an integral part of their investment portfolios, such digital gold options have been catching on. But what gave SGBs an edge over other products like gold ETFs was a set of unique features.

First and foremost, the sovereign gold bonds paid an interest of 2.5% per annum. That was a big positive for investors since gold is normally an idle asset and this bond enabled the investors to earn returns on their gold investment (apart from price appreciation). The other important feature was the sovereign guarantee on the gold holdings and on interest payment. The government guarantees the gold holdings in terms of grams of gold, although the price is something that is driven by global prices. This sovereign guarantee on the quantity of gold held and regular interest were two key features making SGBs attractive. Convenience was another factor since these gold bonds could be held in certificate format or in the demat account. This would do away with the need for physical holding of gold.

But, the biggest attraction was the tax benefits of holding the sovereign gold bonds for the full tenure of 8 years. If the bonds were held for the full period of 8 years and then redeemed, the entire capital gains on sovereign gold bonds, irrespective of the extent of profits, would be entirely exempt from long term capital gains tax. This was a huge benefit because those how had invested in late 2015 and early 2016, ended up with gains of more than 100%, as gold prices more than doubled pre and post-pandemic. This led to substantial gains for investor and the tax-free status of the capital gains meant that the effective yields on sovereign gold bonds made it extremely attractive to investors. However, it also follows logically that what was a huge gain to investors, was a huge cost to the government.

HAS THE GOVERNMENT DISCONTINUED SOVEREIGN GOLD BONDS

While the government had been aggressive in raising funds via gold bonds in the past, there have been no issues of SGBs for quite some time now. In fact, calendar 2024 has seen just 1 tranche of SGBs in February 2024 and the current financial year FY25 has not seen a single tranche of SGBs issued. Senior government officials have admitted unofficially that the cost of servicing gold bonds was too high and it was putting an unnecessary strain on the government. To get a better picture, let us look at the case of the first 5 tranches of SGBs that have already been redeemed by the government of India.

Issue Tranche	Issue Date	Issue Price (₹)	Issue Size (Gm)	Issue Value	Redeem Price (₹)	Redeem Value	Profit Paid	Interest Paid	Total Gov Cost
2015-I	Nov-15	2,684	9,13,571	245.20	6,132	560.20	315.00	49.04	364.04
2016-I	Feb-16	2,600	28,69,973	746.19	6,271	1,799.76	1,053.57	149.24	1,202.81
2016-II	Mar-16	2,916	11,19,741	326.52	6,601	739.14	412.62	65.30	477.93
2016-17 Series I	Aug-16	3,119	29,53,025	921.05	6,938	2,048.81	1,127.76	184.21	1,311.97
2016-17 Series II	Sep-16	3,150	26,15,800	823.98	7,517	1,966.30	1,142.32	164.80	1,307.12
Total of 5 Series				3,062.94		7,114.21	4,051.27	612.59	4,663.86

Data Source: RBI (All figures are ₹ in Crore, unless mentioned)

Here are some takeaways from the case study of the 5 tranches of SGBs that have been redeemed till now.

• The first 5 tranches of sovereign gold bonds between November 2015 and September 2016 saw total gold bonds worth 10.47 metric tonnes (MT). The average issue price of these 5 tranches of SGBs was ₹2,894 per gram entailing total collections of ₹3,063 Crore across these 5 tranches.
• On the completion of 8 years, these 5 tranches have already been redeemed in its entirety. The entire 10.47 MT of gold was redeemed in 5 tranches at an average price of ₹6,692 per gram. Thus, the total redemption value of these 10.47 MT of gold bonds was worth ₹7,114 Crore.
• That entails huge capital gains for the investors in these first five tranches. With a redemption value of ₹7,114 Crore against the issue value of ₹3,063 Crore, these 5 tranches entailed a total long term capital gain of ₹4,051 Crore to investors. That payout has gone out of the government coffers.
• Now let us look at the cost to the government for raising ₹3,063 Crore. Over 8 years, it has redeemed these five tranches at a total redemption value of ₹7,114 Crore. In addition, it has paid interest of ₹613 Crore. That is not all; since LTCG tax has also been foregone by the government. At the current rate of 12.5% LTCG tax, it is revenue loss of ₹506 Crore to the government. In short, government incurred a huge cost on the issue and redemption of the first five tranches of SGBs; sharply higher than 10-year yields. The average annualized cost to the government, is close to 13.16%, which is exorbitant.
• But the real problem is that there is still a huge quantum of sovereign gold bonds that are pending for redemption. Till date, the government has issued 146.96 MT of gold bonds, of which only 10.47 MT of gold bonds have been redeemed till date. In future tranches, the capital gains cost will be lower, but the overall costs are still going to be phenomenal.

The decision by the government to go slow on SGB issues is not surprising. In the first tranches, the average redemption premium has been 131.42%. The government is incurring a cost of 13.16% annually on SGBs redeemed till date, while it can technically raise 10-year debt at around 6.8%. That is really hard for the government to be able to justify. It would hardly be surprising if the government decides to stop the issue of SGBs altogether. That brings us to another question

CAN WE BUY SOVEREIGN GOLD BONDS IN SECONDARY MARKET?

One idea that a lot of financial advisors have been giving to their investors after the likely cancellation of future SGB issues is to buy these SGBs in the secondary markets. Is that a really good idea. Let us look at the 25 most liquid SGBs trade on the NSE.

SGB NSE Symbol	Market Price	52-Week High	52-Week Low	1-Month Returns	1-Year Returns	IBJA Price #	Premium to IBJA
SGBFEB27	8,289.00	8,400.00	5,905.11	6.27	39.29	7,824.00	5.94%
SGBMAY26	8,239.50	8,294.97	5,880.00	6.33	38.01	7,824.00	5.31%
SGBMAR30X	8,380.00	8,600.00	5,940.00	4.37	38.75	7,824.00	7.11%
SGBOCT25V	8,200.00	8,200.00	5,950.00	5.13	36.94	7,824.00	4.81%
SGBOCT25	8,199.99	8,694.00	5,901.01	3.86	37.81	7,824.00	4.81%
SGBNOV258	8,100.00	8,120.00	5,960.11	5.19	35.02	7,824.00	3.53%
SGBJ28VIII	8,245.00	8,400.00	5,911.00	4.90	38.34	7,824.00	5.38%
SGBOCT25IV	8,116.00	8,200.00	5,900.00	4.05	35.92	7,824.00	3.73%
SGBFEB32IV	8,487.00	8,805.00	6,161.00	0.20	N.A.	7,824.00	8.47%
SGBJAN30IX	8,300.00	8,463.00	5,930.00	5.15	39.85	7,824.00	6.08%
SGBFEB28IX	8,249.00	8,865.00	5,921.00	5.47	39.46	7,824.00	5.43%
SGBSEP31II	8,355.00	8,590.00	5,900.05	0.89	41.34	7,824.00	6.79%
SGBSEP27	8,150.00	8,467.00	5,903.00	4.15	37.90	7,824.00	4.17%
SGBNOV24	7,900.00	7,950.00	5,933.00	2.79	31.34	7,824.00	0.97%
SGBJUL25	8,099.00	8,180.00	5,935.21	3.70	34.98	7,824.00	3.51%
SGBSEP29VI	8,245.00	8,395.00	5,902.00	4.30	39.06	7,824.00	5.38%
SGBAUG29V	8,214.00	8,650.00	5,941.00	3.91	38.59	7,824.00	4.98%
SGBJUN31I	8,345.00	8,549.00	5,961.01	1.67	39.39	7,824.00	6.66%
SGBNOV25	8,100.00	8,100.00	5,931.24	3.86	34.35	7,824.00	3.53%
SGBMAR25	8,020.01	8,299.00	5,911.00	1.61	32.86	7,824.00	2.51%
SGBJUL29IV	8,230.00	8,289.00	5,935.00	3.25	38.25	7,824.00	5.19%
SGBJUN28	8,178.00	8,320.00	5,920.00	3.60	38.07	7,824.00	4.52%
SGBMAY29I	8,200.00	8,295.00	5,925.05	3.49	36.77	7,824.00	4.81%
SGBJAN29IX	8,225.00	8,400.00	5,926.05	3.86	38.70	7,824.00	5.13%
SGBDC27VII	8,299.00	8,420.00	5,925.00	3.74	39.13	7,824.00	6.07%

Data Source: NSE (CMP as of March 28, 2024)

Here are some key points that investors must remember before they take a decision to buy the SGBs in the secondary markets.

• The first big issue they need to consider is the premium to the IBJA reference price. You would find that all the 25 most liquid sovereign gold bonds are quoting at a reasonably high premium to the reference rate fixed by the Indian Bullion and Jewellers Association (IBJA). The premium over the IBJA reference rate ranges from 0.97% on the lower side to 7.11% on the higher side. The average premium over the IBJA reference rate for the top 25 most liquid SGBs is around 5%. That is straightaway getting chopped from the returns, so you start off with a disadvantage.
• Secondly, the question is why is there such a premium and will the premiums continue on SGB traded in secondary markets. There are several reasons for the premium. Firstly, the premium also factors the interest payable on the SGB on a half yearly basis and the capital gains tax exemption on redemption. These factors contribute to the premium. In addition, the liquidity on most of the SGB contracts is also thin due to limited supply. Investors are not interested in selling their SGBs in the secondary market and losing out on the LTCG exemption. Also, the demand is currently quite high due to the likely cancellation of future SGB issues. Hence there is a rush into secondary markets.
• If premium is one side of the story, the effective interest you earn will be much lower if the price is much higher. Let is look at the case of 3 most liquid SGBs.

SGB NSE Symbol	Issue  Price	Market Price	IBJA Price #	Premium to IBJA	Interest Rate	Effective Interest Rate
SGBFEB27	3,326.00	8,289.00	7,824.00	5.94%	2.50%	1.00%
SGBMAY26	3,114.00	8,239.50	7,824.00	5.31%	2.50%	0.94%
SGBMAR30X	5,109.00	8,380.00	7,824.00	7.11%	2.50%	1.52%

Data Source: NSE / RBI

As you can see in the above table, for the 3 most liquid SGB instruments on the NSE, the effective interest rate you earn at the current market price would be substantially lower than the 2.5% interest rate that is the committed payment on the bond, since that is the rate payable on the issue price. For secondary markets, it is current yield that matters.

Apart from these factors, there is a more practical consideration of how much further the gold rally can sustain. Gold prices are up by nearly 30% in the last 1 year. That would limit rapid upsides on gold prices. Also, year 2016 and 2017 were multi-year lows for gold prices. It would be naïve to expect such returns at current levels. Investors buying SGBs in the secondary markets would have to factor these into their calculations.

IS BUYING SGBS IN SECONDARY MARKETS A BAD IDEA?

You could still make profits, but the risks are quite high. You may end up paying a premium. You earn much lower effective interest. Above all, there is a steep premium on SGB prices as there is a shortage factor and the tax exemption and interest earnings are factored into the price. However, if the government does resume the issue of gold bonds then the premiums could vanish and we could have discounts, which could even trigger market to market (MTM) losses for the investors. Due to a combination of these factors, buying SGBs in the secondary markets at the current juncture could be less than remunerative.

What is the alternative then? The other options are still open. There are gold ETFs and gold FOFs which you can select. Then, there is the opportunity to buy gold coins either from banks or from reputed jewelers. The bottom line is that buying SGBs in the secondary market at the current juncture, could be fraught with risks and a risk-reward ratio that is clearly skewed against the investor.