Key Difference Between Sovereign Gold Bond and Fixed Deposit
I. Introduction
- Brief overview of traditional investment options in India
India is a major economy with ever-maturing financial markets. Investors in India have the luxury to invest in this highly regulated economy which offers opportunities to invest in unique and new financial products. Although traditional products like investing in gold and fixed deposits haven't lost their appeal, there are many investment avenues which provide the benefits of investing in both traditional as well as modern financial products, like sovereign gold bonds.
- Growing interest in Sovereign Gold Bonds (SGBs) and continued popularity of Fixed Deposits (FDs)
Sovereign gold bonds are currently enjoying a growing popularity amongst the investors. These financial instruments offer the stability of gold, clubbed with the fact that these are government issued instruments, make it suitable for risk averse investors, the stability clubbed with the interest income and gold’s price stability and growth is one of the major reasons why this is a great investment avenue for many!
Fixed deposits (FDs) are traditional investments where the bank offers a fixed interest on the deposits. These are pretty robust financial products, and are great for investors looking for highly liquid and interest earning instruments.
- Purpose of the article: To highlight the fundamental differences to help investors make informed decisions
Understanding the fundamental differences is the most important process to fully understand the financial product in detail, and it helps figure out the suitability for investors as far as understanding suitability from an overall portfolio point of view is concerned. This will help in painting an accurate comparison with respect to SGB vs FD for long-term investment as well as short-term investment timeframe.
II. What is a Sovereign Gold Bond (SGB)?
- Definition and issuer (RBI on behalf of the Government of India)
SGB stands for Sovereign gold bonds. These are debt instruments issued by the Government of India. SGB offers a unique opportunity for the investors where the investor can enjoy regular income in the form of interest earned on the investment. Along with this, since the bonds are backed by gold, the investors also enjoy the value increase as and when the gold rate increases. However, the highlight of this instrument is that if the investor stays invested till maturity, then the returns made in the form of long term capital gains are exempt from LTCG tax (Long term capital gains tax).
- Denomination and gold-backed nature
The sovereign gold bonds are denominated in the local currency i.e. Rupees, and is backed by sovereign gold held by the government. This essentially means that the gold price movement in the market will also have an impact on the price movement of the underlying security.
- Key features:
- Tenure (usually 8 years with early exit after 5 years) : Sovereign gold bonds at the time of issuance come with the maturity tenure. This is typically 8 years, however this may change as per the issuer’s prerogative. There is also a lock-in period which is typically fixed at 5 years, i.e. the investors can sell-off their holding in the SGBs in the secondary market after this lock-in period. One benefit of holding the instruments till maturity is that if done so, then the returns made in the form of long term capital gains are exempt from the otherwise applicable capital gains tax.
- Interest rate (currently 2.5% per annum) : The interest rate is the coupon payment that the investor receives at a regular interval. The returns made in the form of interests are over and above those made in the form of capital appreciation due to increased gold prices. Sovereign gold bond interest rate typically is fixed at 2.5% per annum which the investors receive till they are invested in the bond.
- Price linked to market value of gold : Gold is a stable asset in regards to its price. We have seen a consistent growth in the gold prices over the last couple of decades. One of the biggest benefits of investing in sovereign gold bonds (SGB) is that the prices of SGB are linked to the market value of gold. I.e. a change in the market prices of the gold will result in subsequent increase of the same magnitude in the price of the SGBs. Looking from a long term perspective, this is a great way to earn long term capital appreciation, since gold has showcased a solid growth in its value.
- Redemption in cash equivalent to gold price at maturity : On redemption on maturity, the investor receives the rupee equivalent to the current gold price for their SGB holding. A great thing about this is that the returns made are exempt from long term capital gains tax i.e. SGB capital gains tax is not applied if held till maturity, essentially helping the investors by blocking the negative effect of taxes on the net returns.
III. What is a Fixed Deposit (FD)?
- Definition and typical providers (banks and NBFCs)
Fixed deposits are interest bearing financial instruments offered by banks and NBFCs. How fixed deposits work is that the investor can invest a desired sum with the FD provider, and the sum is then locked for the deemed tenure, and stipulated interest is earned on the principal invested by the investor.
- Key features:
- Fixed tenure and interest rate : One of the key features of fixed interest is that these have a fixed tenure, and fixed deposit interest rates are also constant and determined at the start of the tenure.
- Guaranteed returns and capital safety : This is one of the key reasons why many investors prefer investing in fixed deposits (FD). These financial instruments are great for risk averse investors who would like to get guaranteed returns while ensuring capital safety. This is also a great instrument to normalize risk levels of a portfolio that is otherwise highly risky.
- Flexibility in tenure and interest payout frequency : The banks or financial institutions offering fixed deposits offer various tenure options at the start of the FD placement. The inventors have the flexibility to choose the tenure, and interest payout frequency as per their preference. Depending upon the tenure, the applicable interest rates may also change.
IV. Key Differences : SGB vs FD Comparison
| Factor | Sovereign Gold Bond (SGB) | Fixed Deposit (FD) | | ----- | ----- | ----- | | Risk Profile | Linked to gold price, subject to market fluctuations | Virtually risk-free, fixed returns | | Returns | Interest (2.5%) + gold price appreciation | Fixed interest only | | Liquidity | Lock-in period with limited secondary market options | Easily liquidated with possible penalty | | Taxation | Capital gains tax exempt on redemption after 8 years; interest is taxable | Interest is fully taxable | | Investment Objective | Ideal for wealth preservation and gold exposure | Ideal for capital safety and fixed income | | Form of Investment | Digital/paper, no physical gold involved | Cash-based, deposited with financial institution | | Government Backing | Yes, by RBI and Government of India | Yes, up to ₹5 lakh by DICGC (for banks) |
V. Who Should Choose What?
- SGBs are suitable for:
- Long-term investors : Sovereign gold bonds are a great investment instrument for investors looking to make a long term investment. SGBs offer various benefits that amplify if the investment horizon is on the longer side. First is the benefit of gold price appreciation which impacts the price appreciation of the said instrument, and secondly the tax benefit, i.e. exemption from the long term capital gains tax if the security is held till maturity.
- Those seeking gold exposure without storage hassles : Sovereign gold bonds are also suitable for investors who’d like to get some exposure in gold investment however do not prefer the hassles that comes with investing in physical gold like extra cost incurred for acquiring the gold in the form of making charges, GST, and additional charges such as storage charges. Also, worrying about the safety aspect of it.
- Investors with moderate risk tolerance : Investment on gold also carries market fluctuation risk. I.e. due to various factors such as demand supply forces of the market, geopolitical factors, and this risk exposure also flows to the gold based instruments such as sovereign gold bonds. However, relatively these are still pretty safe investments considering the fact that these are issued by the government of India, also gold has showcased consistent returns over the longer term.
- FDs are suitable for:
- Conservative investors : Fixed deposits (FDs) are a great investment vehicle for investors who would not like to undertake a high risk with respect to their investments. FDs offer consistent returns in the form of fixed interest payments, and high liquidity. Which makes it a great investment instrument for investors who like low risk with respect to consistent returns, and secure.
- Retirees seeking regular income : Since the fixed deposit as a product is designed in a way that it gives constant returns in the form of interest payments, it is a great way to build a consistent income for people who’d not like to undertake high risk like retirees.
- Short- to medium-term savings : FD liquidity is pretty high. It has a fixed tenure post which the investors can withdraw their money, making it a perfect short to medium term interest bearing financial instrument. The investors also always have an option to withdraw premature fixed deposits, however a premature encashment penalty is applicable.
VI. Pros and Cons of Each Option
- SGB Pros:
- Higher potential returns : The sovereign gold bonds (SGBs) have a potential to produce higher returns since these instruments are interest bearing as well as provide the benefit of price appreciation. These two makes it a highly desirable instrument for those looking for an opportunity to make higher returns while taking limited risk exposure.
- Tax benefits on maturity : The sovereign gold bonds (SGBs) offer tax benefits if held till maturity. Since returns made over a long term in the form of capital appreciation attract long term capital gains tax, if these instruments are held till maturity, then the returns made in the form of capital appreciation are exempt from the LTCG tax. However, it is important to note that the interest income earned through regular interest payment is not tax exempt and is taxed as per the investors’ tax bracket.
- SGB Cons:
- Limited liquidity : One of the few drawbacks of the sovereign gold bonds (SGBs) is that these financial instruments have limited liquidity. This is due to the fact that these are very limited in number, i.e. only a limited number of SGBs are issued by the government, this leads to less trading volume in the secondary market and essentially less liquidity.
- Subject to gold market volatility : The SGBs are pegged against gold. A movement in the gold prices reflects in the movement of SGB prices too. This results in the instrument’s volatility in price being equal to that of volatility in gold prices, which can be high during times of economic or geopolitical uncertainty.
- FD Pros:
- Safety and predictability : One of the main reasons why people invest in fixed deposits (FDs) is that it offers safety and predictability to the investor’s portfolio. Fixed deposits are interest bearing instruments, offering high liquidity, and stable returns. These qualities make it a perfect investment opportunity for risk averse individuals and for those who are looking to decrease the overall risk exposure in their portfolio.
- Easy to open and manage : Fixed deposits (FDs) are offered by banks and financial institutions. One of the biggest pros of opening a FD is that it is extremely easy to open and manage.
- FD Cons:
- Lower post-tax returns : The returns made from fixed deposits in the form of interest income will attract the relevant capital gains tax. The taxation has a negative effect on the net returns generated using fixed deposits, because after adjusting for the applicable taxes, the returns diminish, making the net returns lesser than what was anticipated.
- Inflation-adjusted returns may be low : Another effect that eats into the effective returns made with investment in fixed deposits (FDs) is the inflation effect. As you know, inflation results in a decrease in the purchasing power of money, which means that the overall returns made when adjusted to inflation decreases the purchasing power of the money made in the form of interest income.
