Primary vs secondary market: The best way to invest in sovereign gold bonds

Sovereign Gold Bonds (SGBs) present a unique investment opportunity, combining the potential for capital appreciation tied to gold prices with the added benefit of interest income. The Reserve Bank of India (RBI) offers these bonds with a 2.5% annual interest rate, paid semi-annually. Moreover, holding SGBs until maturity, typically eight years, renders the returns from capital gains tax-free. Investors can either buy SGBs directly from the RBI during their primary issuance or purchase them from the secondary market where older issues are traded. Deciding between these options requires careful consideration of various factors, including pricing, availability, and potential returns.

Primary Issuance of SGBs

Buying SGBs during the primary issuance period involves purchasing directly from the RBI. This method is straightforward and ensures that you acquire bonds at the officially set issue price. Every few months, the RBI opens a new tranche of SGBs, allowing investors to participate in fresh issues.

Advantages of Primary Issuance:

Simplicity: Buying directly from the RBI is a straightforward process without the need to navigate secondary market complexities.

Guaranteed Purchase: Investors are assured of getting the desired amount of SGBs without the risk of insufficient availability.

Direct Calculation of Interest: The 2.5% interest is directly calculated on the issue price, ensuring transparency in returns.

Secondary Market Purchase

Alternatively, investors can buy existing SGBs from the secondary market, where older issues are traded on stock exchanges. These bonds are sold by investors who for various reasons, choose not to hold them until maturity.

Why Investors Are Attracted to Secondary Market SGBs:

• Discounted Prices: SGBs in the secondary market often trade at a discount to their intrinsic value due to lower demand. Investors can sometimes buy these bonds at prices lower than the prevailing gold rates, providing an opportunity for higher potential returns.
• Liquidity Needs: Sellers in the secondary market may be those who need liquidity before the bond's maturity, creating buying opportunities at attractive prices.

Considerations for Secondary Market Purchases

While buying SGBs at a discount in the secondary market may seem advantageous, there are several important factors to consider:

1)Volume and Availability: One of the significant challenges in the secondary market is the low trading volume of SGBs. On some days or weeks, there may be minimal to no trading activity, making it difficult to buy the desired quantity at a consistent discount. For instance, if you aim to purchase 100 units, you might find that only a small portion is available at the optimal discount.

2)Variable Discounts: Discounts in the secondary market can vary significantly. For example, you might find 10 units at a 1% discount while the remaining units are available at a 0.5% discount, making it less attractive overall.

3)Brokerage Costs: Purchasing SGBs in the secondary market involves paying brokerage fees, which can eat into the savings gained from buying at a discount. These costs should be factored into the total investment cost to determine the actual benefit.

4)Interest Yield: The interest on SGBs purchased from the secondary market is calculated based on the original issue price, not the purchase price. For example, if you buy a bond originally issued at Rs 5,500 for Rs 6,500, the 2.5% interest is calculated on Rs 5,500, resulting in an effective yield lower than 2.5%. In this case, the annual interest received would be Rs 137.50, giving an effective yield of approximately 2.12%.

Tax Implications and Holding Period

One of the primary benefits of holding SGBs until maturity is the tax exemption on capital gains. However, selling SGBs in the secondary market before maturity can negate this tax advantage. Furthermore, investors selling before maturity might encounter the same low-demand issues that allowed them to buy at a discount initially.

Conclusion

Both primary and secondary market purchases of SGBs offer unique advantages and challenges. Primary issuance provides simplicity, guaranteed allocation, and straightforward interest calculations, while the secondary market offers potential discounts and opportunities for higher returns. However, the secondary market also comes with risks related to low trading volumes, variable discounts, brokerage costs, and potential tax implications.

Investors should carefully weigh these factors based on their individual financial goals, risk tolerance, and investment horizon. Those who hold the bonds until maturity might find the primary issuance more straightforward and beneficial, while savvy investors who can navigate the secondary market's complexities might uncover valuable opportunities. Ultimately, thorough research and a clear understanding of nuances of each options are crucial for making an informed decision.