Last Updated on Aug 26, 2021 by Aradhana Gotur

Take a peek into your own budget – the amount of expenses you need to make in a month against the income you earn. Now imagine the incomes and expenses of the government.

Taxes are a big source of revenue for the government to meet its budget requirements. The government also borrows from banks and non-banking financial companies to conduct its business. In addition to this, the government raises funds by issuing securities such as bonds to investors.

The proceeds from the sale of government securities are then used in nation-building, infrastructure development and other works. After the maturity of the bond, the investor receives the principal amount along with interest paid by the issuer. 

From an investor’s perspective, government securities are one of the most secure forms of investment instruments with minimal risk. Let’s deep dive to understand this investment avenue.

This article covers: 

What are government securities? 

Government securities are a type of financial instrument where investors can park their extra savings to earn a fixed interest and grow wealth over time. There are various types of government securities such as treasury bills, bonds, notes, among others. Also, government security is a debt instrument.

That is, as an investor, you provide a loan/debt to the government so that it can fund its projects. Both central, as well as state governments, issue bonds in order to meet their budgetary expenses. The investor’s money is safe with the government, and also the investors get a fixed interest on the capital invested. 

Why does the government issue securities? 

Government securities are a debt financing option for the government. The government uses securities like bonds to raise funds to expand its operations and build infrastructure. One example could be to buy supplies from the farmers, or even to build roads and complete other infrastructure projects such as metros, highways, and railways lines. All of these projects require a large amount of capital, which the government funds by issuing bonds to the general public.

Governments also borrow money from banks and other non-banking financial institutions. However, banks charge a hefty interest rate on loans. Raising funds using its own securities is cheaper for the government.

Who can invest in government securities (G-sec)? 

Earlier, only the banks and other financial institutions were allowed to buy and hold government securities. But, since 2001 the norms have been relaxed, and 5% of the funds can be held by retail investors. These retail investors can be institutions or individuals.

Usually, the bonds are issued by an auction, therefore, only banks and other large financial institutions are allowed to bid for the bond auction. After the bidding is completed in the primary market, the bond comes into the secondary market for trading. This is when the retail investors can get their hands on government securities as an investment.

Types of government securities 

Government securities are often considered risk-free and make excellent investment opportunities for risk-averse investors, or even for more daring investors looking to diversify their risk. Let’s understand the various options available.

Treasury bills (T-bills)  

Only the central government can issue T-bills. These are money market instruments with a maturity period of less than one year. The government issues three types of bills, with a maturity period of 91, 182, and 364 days. Investors can choose one depending on the liquidity they want. 

The most important thing to note is that T-bills do not pay any interest to the holders. To make money in the market, investors buy T-bills at a discounted rate and sell at a premium.

Cash Management Bills (CMB) 

Launched in 2010 by the Government of India and RBI, these are comparatively newer money market instruments used by the government to meet its short term cash flow mismatches.  

However, maturity is one factor where CMBs are different from T-bills. The maturity period, in this case, is less than 91 days. They are considered a short term investment product. Like treasury bills, they are issued at a discount rate (for example, you may pay Rs. 97 for a Rs. 100 bill) and then redeem it at maturity date for Rs. 100.

Long-term government securities 

Unlike CMBs and T-bills, the maturity of these securities is longer than one year. They are popularly called dated government securities. The maturity of these securities typically ranges from 5 yrs to a maximum of 40 yrs. Investors also earn a fixed interest rate when they invest in a government security. The interest rate can be both fixed and floating. Interest is received quarterly on the total amount of capital invested.

The nine types of G-secs provided by the Government of India are listed below:

  • Fixed-rate bond
  • Floating rate bond
  • Capital bond
  • Inflation index bond
  • Bonds with call/put option 
  • Special securities 
  • STRIPS
  • 75% Savings bonds
  • Sovereign gold bonds 

State development loans (SDL)

The state development loan as the name suggests is issued by the state government. It is used to fund the state’s development projects and budgetary needs. The functioning of the SDL is similar to other government securities.  The basic difference between both of them is that SDL is issued by the state government and the G-sec is issued by the central government. 

Features of government securities

  • The majority of the government securities are issued at their face value and no premium is added to the price.
  • Government securities guarantee fixed income to the investors.
  • The liquidity in the secondary market is high as compared to the primary market. Therefore, retail investors get high liquidity in the secondary market and you can directly sell in the secondary market. 
  • No tax is deducted at source in the case of government securities. 
  • The premium, face value, and rate of interest are fixed at the time of issuance and they can not be changed once the security is issued. 
  • Investors can store government securities in dematerialized format. 
  • In the case of redemption, the securities are redeemed at face value. 
  • The maturity tenure ranges between 2-30 yrs. 

Limitations and risk of government securities 

  • The interest rate on government security is marginally low as compared to the other financial instruments. 
  • Government security loses its value when inflation in the country rises. 
  • The long-term returns are low as compared to other asset classes. 
  • When the government enters into a fiscal crisis, due to the vulnerability the security loses its value. 

Risks involved 

There are two types of risk involved in G-sec.

Credit risk: There is always a risk of non-payment of the principal amount and the interest rate. Although, in the case of government securities, the risk is almost negligible. But, investors should be diligent, and always check third-party ratings before making any investment. 

Inflation risk: When inflation is rising, the low interest on the bonds does not attract a lot of investors. Therefore, inflation affects the purchasing power and viability of these instruments. However, there are inflation-linked bonds that increase the principal and interest amount of the investor when inflation is rising. 

How do investors make money by investing in a government security

The return generation in the G-sec segment depends upon the type of G-sec investor chooses. If the investor wants a fixed half-yearly income, they can choose G-sec with coupon rates. 

Also, some of the G-secs can be bought at a discounted rate by the investor. They are redeemed at a premium at the time of maturity. Thus, investors can make money in these two ways by investing in the G-sec. 

The G-sec or government bonds are issued by the Reserve Bank Of India (RBI) on behalf of the government. RBI focuses on reducing the fiscal deficit of the ruling party. Over the years, G-sec has gained a lot of popularity and attraction. 

Moreover, the process of investing in G-sec has been made very feasible. Now, investors can choose to invest in G-sec via mutual funds as well. Therefore, the volatility has increased and Asset Management Companies are responsible for it.

Aradhana Gotur