Why the new Sovereign Gold Bond Scheme makes investment sense…

The original Sovereign Gold Bond Scheme launched last year did not really set the turnstiles on fire. There were quite a few reasons for the same. Firstly, the pricing was not very attractive. The price of the Sovereign Bond Scheme was higher than the spot price of gold which made it prima facie unattractive. Secondly, last year the price of gold was on a down trend and equities were having a fairly good time. This really did not entice the retail investors to give up equities in favour of gold. Last but not the least, the product was still not well understood by the investors and hence there was reluctance to jump into a lock-in product. The second tranche of Sovereign Gold Bonds may however be a tad different.

Some key features of the Gold Bond Scheme…

Essentially, the Gold Bond scheme is a means to hold the gold in non-physical form. There is an economic rationale to it. The love for physical gold has made India a major importer of gold. For the month of December, the imports of gold were up nearly 180% at $3.8 billion. This is not exactly a healthy scenario as precious foreign exchange reserves are dissipated to procure an asset which is not exactly productive. A gold bond scheme makes sense as it lets people hold gold as a security rather than in physical form.

The bond will have a tenure of 8 years although the lock in will be technically released on completion of 5 years. At the end of five years, one can exercise their option to exit. It needs to be remembered that the Gold bonds will be denominated in terms of grams of gold. Thus your quantum of hold remains constant and the value of the bond is subject to the movement in gold prices. The interest rate of 2.75% makes it fairly attractive to investors who want to earn interest on gold rather than keeping it idle in their vaults. The gold bonds can be bought in denominations of 1 gm and can range from 2 gm to a maximum of 500 gm. Of course, this limit of 500 gm is per applicant and hence if there are 4 members, each of them can avail up to 500 gm of gold bonds.

To add to convenience, the bonds can be held in the form of physical certificates or in the form of demat holdings. Additionally, these bonds can be used as collateral for loans and the loan to LTV value will be exactly the same as pledging your physical gold.

Merit 1 – Pricing is more attractive…

The government of India has ensured that the pricing of the gold bond is attractive. It has been priced at Rs.2600/gm which is slightly below the market price. This adds to the attractiveness and yield of the gold bond. In the previous occasion, the bond was priced at above the market price and hence became a non-starter.

Merit 2 – Emerges as a new and distinct asset class…

Eventually investors will see the merits of holding gold in non-physical form. Post the rate cuts by the RBI, most banks have cut their rates of lending as well as their deposit rates. This has made bank FDs less attractive as an asset class. Also, real estate has become too erratic of late and the assurance of positive returns over the medium to longer term is no longer there in real estate. With global rates rising and China in turmoil, equities are likely to be hit by weaker currencies and economic slowdown. Under these circumstances, gold will emerge as a distinct investment class. That process can be facilitated by these gold bonds.

Merit 3 – They are liquid in a different way…

One can argue that you do not have the liquidity of equities or mutual funds in a gold bond. That is correct due to the 8 year lock in period and the 5 year exit window. But it is very easy to pledge these gold bonds and raise a loan against these bonds. Unlike equity or mutual funds, the loan to value (LTV) ratio is much higher for gold bonds as the volatility in prices is not too high and there is the backing of the government of India. The haircuts are much lower in case of gold bonds, so that makes these bonds liquid in a different way.

Merit 4 – This time it may be actually different…

In investing, the most dangerous 4 words are supposed to be, “This time it is different”. But this time it may actually be different for gold. Gold has globally fallen from $1900/oz in 2011 to $1050/oz currently. Secondly, the current turmoil in global politics and economics will ensure that there is a safe haven demand for gold. That will also make the gold bonds more attractive. Also investors will look to move some of their gold portfolio into gold securities and that may benefit these gold bonds.

What better can be done from here on?

There are a few things the government may consider to make these gold bonds more attractive…

  • Tax benefits either on the interest component or on the investment made can be considered to give an initial fillip to this product. It may not cost too much and may serve the government purpose of reducing the import of gold.
  • The biggest risk for the price of gold is dollar value. Typically a strong dollar has been synonymous with weak gold prices. That is a risk all the gold bond holders are exposed to. The government needs to explore means of helping hedge this risk at a macro level.
  • Currently, these bonds are available only when the issue opens. Instead the bonds can be made available on tap. This will ensure that serious small investors can also look to do an SIP on gold bonds by buying something like 5 grams each month. This facility is not available right now and can be a big boost for the gold bond scheme.
  • The KYC process can be substantially simplified. If a person has already gone through KYC for his bank account then that can be taken as a proxy KYC for the gold bonds too.
  • Once the bonds are allowed to be traded in the bourses, the government can look to appoint market makers to give two-way quotes to make the entire secondary market more meaningful.

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

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