In today's newsletter, we talk about sovereign gold bonds and why these things don't dominate your investment portfolio.
The Story
On April 20th, the Reserve Bank of India will begin issuing a fresh batch of sovereign gold bonds on behalf of the government, effectively kickstarting their latest borrowing program.
And here’s how it works. You say you want 20 gms of gold and pay in cash right now based on rates set by the bullion association. The government says okay. It takes your money and then whips out a piece of paper — A promissory note to pay you exactly what these 20 gms will be worth 8 years from now.
So instead of holding the actual physical gold. You can hold these bonds instead.
Potential Upside: Nobody can steal it from you
Potential Downside: You can’t sell it at your next-door pawnbroker
And since the government is expected to honour its obligations, you will almost certainly receive your money on maturity day (after 8 years that is).
In addition, you also get to earn a cool 2.5% interest (every year, paid semi-annually) on the amount you invest. And if all goes well, you can also proudly claim that you helped the government in its hour of need.
All very nice!!!
The problem, however, is that these gold bonds haven’t exactly surged in popularity. Because we Indians — we need something that we can touch, caress, hold and even flaunt at the occasional kitty party. We don’t need a piece of paper. We need a cultural unifier.
But what if we are talking about a rational investor. Somebody who can evaluate the merits of an investment option based on the cost and benefits associated with it. Somebody who is not my mother for instance (bad investor, but a lovely lady)
Surely, these sovereign gold bonds would be a prudent investment option, no?
Maybe… But there’s almost unanimous consensus that it’s only good in tiny quantities. Not if you are doing it in bulk.
But hold on. This doesn’t make any sense. If anything, gold has done quite well as an asset class. In the past 15 years, it’s offered investors a compounded annual return of close to 9.8%. Compare that to 8.4% CAGR from US Equities (DJIA) and you could even make a case for why gold can sometimes outdo the best of the lot.
Now, this doesn’t even include all the extra benefits sovereign gold bonds have to offer compared to just plain tangible gold. We are talking about zero making charge, an exemption in taxes (if you hold the bonds until maturity) and some extra interest on top. Clearly. financial advisors are acting against their clients' interests when they compel them to set aside as little money as possible whilst betting on these bonds.
What they should be doing instead is atoning for their sins. Maybe they should all band together and sing in perfect unison — “gold bonds sahi hai” like those mutual fund people. That would be a good place to start, especially considering all the muck they’ve thrown at gold these past few years.
Right?
Well….
Not quite.
You see gold does have its upside, especially when you are talking about the glory years. Nobody’s disputing that. But it also has a dark side, a side we call volatility.
Consider for instance what happened in 1979. That year, gold prices rallied a whopping 120 %. The next year, it rallied some more — 29%. Unfortunately, things took a rather ugly soon after. In 1981, gold lost 32%, and it never really recovered after that. Not until 2006, when priced finally hit the $594 mark — the same price it was trading at, back in 1980.
The point is — Gold is very moody. The upswings and downswings here are extremely pronounced. It’s very difficult to say what gold is likely to do next. In fact, more often not you won’t have the tiniest clue on what it’s going to do next.
Do you think people back in 1980 could foresee gold would never hit the highs it made that year, for another 26 years?
Hell no!!! And that’s precisely the reason why investors don’t necessarily like to hold gold in large quantities. 10% of your portfolio, maybe. 25% — That’s a bit too much.
Also, once you buy one of these sovereign gold bonds, you are expected to hold them for at least 5 years (although the maturity is 8 years). Meaning you’ll have to tie up your cash for an extended duration and hope and pray that gold does a miracle sprint during this time. Unfortunately, this bit isn't very palatable for more people.
So does that mean, these sovereign gold bonds will go unsold? Will the government have no money to borrow when judgment day arrives? How will they fund the spending program intended to mitigate some of the economic consequences of the pandemic?
Well, not to worry. Because despite the litany of problems we’ve already noted, gold is still an extremely reliable store of value. Especially when you are trying to beat inflation. And if you are a large university or a temple trust with millions to spare, setting aside some money on these bonds is most definitely a prudent option.
So come Monday, when the first set of sovereign bonds hit the market, the trusts, and the universities will be ready. Maybe some individual investors too. And if all goes well, the government will have plenty to borrow and we can continue to breathe easy.
Until then…
