India is the largest consumer of gold in the world. On average, India imports $35 billion worth of gold a year, amounting to almost 25 per cent of the trade balance of the country. Economists have long derided the tendency of people to use gold as a saving instrument. Despite the emergence of many alternative instruments, the average Indian's love for gold continues unabated. Governments have long tried to convert gold into financial savings in the hope that money saved can be more 'productively' used. Despite this, physical gold holdings continue to remain a preferred investment option. In this context, the recently launched gold bond is an interesting investment option.
Gold does beat inflation - much of the time
A key requirement for any investment method to be attractive is that it should beat inflation over the long term. India, till recently, has suffered from sustained inflationary pressures. Often, bank deposit rates have lagged behind inflation, delivering negative real returns to savers.
Gold, a physical asset, has appreciated over time, though in a patchy manner. For example, if you held onto gold for a period of eight years (I'll explain why eight years in a while) starting 1987 onwards right until 2005, the investment would have underperformed inflation. This was also the time when many central banks in the world decided to pare down their gold holdings, leading to soft gold prices. This changed post 2005 as gold witnessed an unprecedented rise in prices, leading to a five-fold increase till 2014, after which prices softened again.
As an average, if one had invested in gold since 1979 onwards for any eight years, in 11 out of the 28 periods till 2014, one would have lost vis-a-vis inflation, while gaining over the rest of the 17 periods. Also, averaged over the entire 35-year period, gold returns exceeded inflation by a bit over 2 per cent.
Gold bond
The recently announced gold bond offers an interest rate of 2.75 per cent to investors. Issued with a tenor of eight years, (the reason for the eight-year analysis is in the earlier paragraph) the instrument has an exit option after five years. The way it works is that an investor will buy a gold bond (representing X gm of gold) at the market price of gold on the date of issue. On redemption, he gets a value equal to prevailing price of gold on the sale date for the X gm he owns. In other words, the bond represents a fixed amount of physical gold. In addition, while he holds the bond, it continues to pay 2.75 per cent per annum.
Hedging the instrument
For an issuer to offer this instrument, the issuer would receive the bond value from investors for a period of eight years. In return, the issuer has to pay coupon rate (2.75 per cent) and pay out an equivalent of the upside, if any, in gold prices over that period. Note that the issuer will not actually buy the gold. In effect, the issuer has to hedge his position by creating a synthetic 'bought call option' position with the money received and generate income using the rest to pay coupon.
In this case, the issuer is the Government of India (GoI). For sake of simplicity, let us assume that GoI borrows eight-year money at 7.5 per cent. It pays 2.75 per cent to holders of gold bonds. In other words, government saves 4.75 per cent (7.5 per cent minus 2.75 per cent) per annum, which is what is available to 'purchase' a call option on gold.
A rough calculation suggests that an option on gold for eight years should be valued at about 30 per cent of current prices. Compensating for the timing of cash-flows, it implies that GoI is maintaining its cost of borrowing at the current level.
In theory, the government could have made the bond even more attractive by offering the full benefit of the implied 'call option' to the investor without an additional cost. What that would mean is that investors would not lose money if gold prices fell but would gain if they rose. They would additionally get the coupon rate. This may well have resulted in a very large portion of government borrowing transforming into gold bonds - probably not what GoI desires.
For the government, a cut in interest rates on the long bond will mean that the pricing offered is less attractive. Additionally, it requires the RBI to constantly hedge positions. It is likely that the RBI will hedge only partially and take a positional view, or engage in 'delta hedging' - a dynamic hedging method. In either case, gains or losses will depend on market the timing skills of RBI's dealing desk.
Who should buy these bonds?
Anyone who is a bull on gold prices or plans to hold gold for the long term for whatever reason should find this a no-brainer. It converts a play on asset prices into an 'income + asset price' play. As a pure investment for investors who actively allocate money across asset classes, assumptions on the direction of gold price will be more important. If the view is negative, one should stay away.
The direct benefit of this plan is that it reduces requirement to import gold to the extent of subscription. This will reduce pressure on foreign reserves. Another benefit is that this bond is likely to be a popular government security with retail investors. It will widen the base of government borrowing - something that the RBI has attempted time and again and failed miserably.
As a means of getting more people into financial savings as opposed to physical savings, it is a step in the right direction. Companies lending against gold jewellery may suddenly find their margins under threat as lending against gold bonds becomes less risky and less cumbersome (no physical infrastructure needed to value gold or store gold ornaments). Higher safety for lenders will open up the market in terms of newer lenders offering loans against such bonds.
Many jewellers and gold-loan companies offer 'saving plans' in the form of systematic investment in gold. If available on tap, these bonds have the potential to eliminate these dubious practices. The scope to transform small savings and bring small investors into the formal system is extremely large.
Anand Tandon is an independent analyst.
This column appeared in the December 2015 Issue of Wealth Insight.
This article was originally published on January 07, 2016.
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