Most Indians are familiar with the box of gold jewellery, carefully stored in the Godrej almirah or bank locker. Buying gold is not new for Indian investors –  it is a traditional way to save and provide inheritance. And it is easy to resell - as the writer Ken Alstad noted, “Second hand gold is as good as new.” 

Over the past 10 years, gold prices increased by a CAGR of 6.49., In just the past six months, it jumped by 9.54%. The recent uncertainty in the financial world and stock markets have increased investments in gold. 

Gold also acts as an effective hedge against inflation. Central banks tend to buy gold as a protection against high inflation. In CY22, central banks across the globe purchased 673 tonnes of gold – the highest in the past 55 years. Besides central banks, broader investors are also buying gold, which pushed gold prices to an all-time high in Feb-2023.

Gold has not disappointed retail investors in terms of returns as its prices have gone up by a CAGR of 12.56% in the past 15 years.

Five-year rolling returns of physical gold have declined between 2014 and 2019. As investors move towards paper gold like Gold Bees (Started by Reliance Nippon in 2007) and Sovereign Gold Bonds (SGB), the demand for physical gold has decreased over the years. 

Physical gold performs better than Gold Bees

Gold Bees are similar to physical gold and are exchange-traded funds. It was first launched in India by Reliance Nippon in April 2007. Gold Bees are backed by physical gold. For every investment made in Gold Bees, ETFs buy a proportionate amount of gold.

If we compare the price changes of physical gold to net asset value (NAV) of Gold Bees, the former fares better in the longer run. Since the launch of Gold Bees in April 2007, it has given returns of 11.51% CAGR, while physical gold gave 12.56% in the same time period.

The differential of 1.05% is on account of the expense ratio of ETFs. The churn coupled with storage charges eats away at the returns. Currently, Nippon India ETF Gold Bees have an expense ratio of 0.82%. Their lower returns and inability to be used as collateral limit the value proposition. Hence, Gold Bees are preferred for short-term investments only. 

Indian retail investors are the driving force behind gold prices – India consumes 25% of the world’s gold production, coming in second after China. India’s gold consumption in CY22 stood at 774 tonnes and it was 1,002 tonnes in China. While lower than the previous year, rising gold prices have limited retail consumption. 

Higher consumption of gold is an economic concern for India. India is a net importer of gold, India has a greater trade deficit, which shoots up dollar prices. To fill the fiscal deficit caused by the stronger dollar, the government has to borrow more. To combat this problem and limit gold imports, the government introduced a 12% import duty on gold in 2013. The government also introduced sovereign gold bonds (SGBs) to lure away retail investors from physical gold. 

What are Sovereign Gold Bonds?

Sovereign Gold Bonds are designed to imitate actual gold in terms of monetary benefits. It moves in accordance with price changes in physical gold. On top of this, the government pays a coupon interest rate of 2.5% per annum (paid semi-annually) on the nominal value of the bond. SGB has a lock-in period of five years and a redemption tenure of eight years. After the lock-in period, investors can sell the bond in the secondary market. SGB is as good as gold but in paper form. It’s like buying gold and earning an extra 2.5% interest on top of it.

SGBs aim to wean investors off physical gold and reduce the import burden on the Indian economy. It also lets the government borrow at a cheaper rate of 2.5%, which is much lower than the standard rate of 5%-6%. It’s a win-win situation for retail investors and the government.

Features of Sovereign Gold Bonds over physical gold.

·       SGBs pay a coupon interest rate of 2.5% (paid semi-annually) per annum on the nominal value.

·       There are no safety/storage concerns associated with SGBs as it is available in demat and paper forms. 

·       Its redemption price is based on the average closing price of 999 gold over the previous three business days. The prices published by the India Bullion & Jewellers Association (IBJA) are considered for this. This system ensures the purity of gold and eliminates worries over wastage. 

·       Chances of default are minimal as the bond is backed by the government. 

·       The bond is issued in multiples of 1 gram and can be traded on the NSE.

·       The minimum investment prescribed for individuals and Hindu undivided families (HUF) is 1 gram and the maximum is 4 kg. For trusts and charitable institutions, the limit is 20 kg.

·       Even though the maturity period is eight years, SGBs are redeemable after five years, on every interest payment date.

·       Capital gains from redemptions are tax-exempted. Gains from the sale of bonds are considered long/short-term capital gains and interest earned is considered under income tax laws.

·       SGBs can be used as collateral for loans. The loan-to-value will be in line with a normal gold loan. You are not required to pay valuation charges for SGB-backed loans.

SGBs give better returns than Gold Bees and physical gold

Indian retail investors find comfort in owning physical gold but SGBs beat it in value proportion. Returns from SGBs have been superior to physical gold and Gold Bees. This is besides the added advantage of zero storage/safety costs and 2.5% interest rate from the government. 

The chart below compares five-year rolling returns from physical gold, Nippon Gold Bees and SGBs over the past 10 years. Since SGB was only introduced in 2015, we have taken SGB at the same price as gold since April 2007 and added a CAGR of 2.5% YoY. Based on this calculation, the 5-year returns of SGB would have been always higher by 13.14%.

SGBs have outperformed other gold products over the years and are suitable for long-term investments. Even though Gold Bees have underperformed consistently since its launch, it does not take away its short-term benefits. 

SGBs, even with their superior returns, have not been able to tame India’s gold consumption. If an investor is looking to ride gold prices along with bank-like interest rates, SGBs clearly stand out. Even parents planning for their children’s marriage could opt for SGBs in the long term as it could be redeemed and bought in physical gold. Or the SGBs can be retained for future growth.