Gold available at 10% discount - should you buy?

Before you jump to key in the buy order understand the investment proposition involved. For beginners, SGB are issued by the Reserve Bank of India (RBI) on behalf of Government of India and track the price of one gram gold.

In each issuance, RBI specifies the price of the bond at the time of issuance. The bond comes with eight years term and after five years the investors have the option to opt for early encashment.

The best thing about this bond is it fetches interest income to the investor at the rate of 2.5% per year. The interest pay-out on offer makes it a compelling buy for gold investors, as no other way an investor can earn any income from gold.

“For long term investors not looking for intermittent liquidity, SGB is a better investment option over gold ETF as the SGB offers interest income and there is almost no cost involved in holding these bonds. Gold ETFs though offer liquidity, do not offer any income and do charge investors in the form of expense ratio,” says Anil Rego, founder of Right Horizons – a financial advisory firm.

The SGBs are listed on the stock exchanges and one can trade in them if held in demat accounts. At the time of redemption, the bonds will fetch the price of gold to the investor. To make it further compelling, there is no capital gains tax payable by the investor if the bonds are held till maturity.

However, if you choose to sell before redemption, then the gains are taxed as long term capital gains if held for three years or more at the rate of 20% post indexation. The short term capital gains are taxed at a marginal rate of tax.

Prateek Pant, co-founder and head of product and solutions at Sanctum Wealth Management says, “We have a neutral view on gold since gold does not generate any cashflow for the investors. If you want to buy gold from the asset allocation point of view, then it will be prudent to buy it through the sovereign gold bond.”

Also, there are experts who have a positive view of gold given the possibility of enhanced volatility. You can read about it here.

You must be wondering by now, if all is so good about SGBs then why are they available at a massive discount?

“Though SGBs are attractive means to take exposure to gold, they are not liquid in the secondary market given low investor interest,” says Anil Rego.

A look at the trading volume of the SGB on the stock exchanges connotes the same. The most active series of SGB records volumes in few hundreds on a given day. Most series record volumes in double digits. That is very low for efficient price discovery. Low demand for SGBs lead to low volumes and low prices. No wonder the sellers have to settle for a price much lower than the prevailing price.

Most investors may undermine this element while buying SGBs. However, it will have a big bearing on your investment return. “If you cannot hold on to your investments in SGBs and the liquidity remains low then you have to sell the SGB at a discount,” says Anil Rego.

That means you cannot pocket the discount you get at the time of buying the SGB. The mispriced security will remain mispriced.

Can the mispricing correct?

One needs to understand that the mispricing is arising out of poor liquidity. The poor liquidity is an outcome of low investor interest and low investor interest is an outcome of the dull show posted by gold over the past few years. Over past five years, gold exchange-traded funds (ETFs) - another financial means to invest in gold - gave 0.9% returns to investors. Gold ETFs have seen net outflow of Rs 305 crore since April 1, 2018, as per data provided by Association of Mutual Funds in India.

“No one would like to hazard a guess about if and when the secondary market for SGB will turn liquid. If the gold prices see a significant up move outperforming all other asset classes by a wide margin, then the investors may come back to SGB and the discount at which they quote in the secondary market may shrink or even disappear,” says a fund manager who wished not be quoted.

“If you want to invest in SGB, you should be prepared to hold till maturity,” says Prateek Pant. As the SGB nears the maturity date, the discount to the spot gold price should shrink gradually. At the time of maturity, the investor will be paid the prevailing price of gold. Holding till maturity also ensures that you do not pay tax on long term capital gains if any.

If you are a long term investor in gold then this should appeal you. For short term tactical investors, gold ETF may make sense. If you intend to go for SGB in the secondary market, follow the price discipline. You have to buy in small lots given the low liquidity. One large buy order will do away discount.

The staggered purchases also help you to average the gold prices. You may also want to buy across various series of SGBs. This will ensure that your investments in SGB will also mature at varying dates. It will protect you from the timing risk at the time of redemption. If the gold prices were to fall at the time of redemption, you will lose out. But if you buy SGB maturing at varying dates, then this risk stands minimised.