The investor interest in gold shows no signs of ebbing with the news on global and domestic economic front and geo-political tensions continuing to be negative. These are the conditions when gold as an asset class thrives as there is a flight to safety. Of the many options available to investors to buy gold, including holding it in physical form and digital form, sovereign gold bonds (SGBs) and gold ETFs and funds seem to score on quality, ease of holding the investment and safety. Let’s take a look at them.
What are they?
SGBs are periodically issued by the RBI on behalf of the government and each bond represents one gram of gold of 999 purity. The bonds are issued and redeemed at a price that reflects the prevalent price of gold. Investors also receive an annual coupon of 2.5% on the bonds.
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Gold ETFs on the other hand are mutual fund products that issue units against physical gold held in custody of the designated custodian under Sebi regulations. Each unit represents one gram of gold of 995 purity. The value of the units will represent the value of the underlying gold. Gold funds are mutual funds that invest in the units of gold ETFs and let investors invest without the hassle of having a demat and trading account to buy, hold and sell ETF units.
The SGBs are issued for a fixed tenor of eight years, after which they are compulsorily redeemed, and the prevailing value of bonds is paid out to the investors. Investors who have longer investment horizons will have to reinvest the proceeds either in the primary market or in the secondary market. However, primary market issuances only happen according to the RBI schedule and there may not be an issue at the time of reinvestment. In the secondary market, the availability cannot be assured, leading to money remaining uninvested for a period of time. Gold ETFs and funds are open-ended schemes and there is no fixed tenor and one can redeem the units at any time. This allows them to have continuous exposure to gold as long as their goals demand, without worrying about the impact of reinvestment.
Price and liquidity
The issue price for each bond of SGB in the primary market is the simple average of the closing price of gold of the defined purity in the last three days of the week preceding the issue. For bonds purchased in the secondary market, the price will reflect the value of gold and will also factor in a premium or discount depending upon the demand and supply. “If my investor has an eight-year holding period, SGBs are the automatic choice," said Naveen Rego, a registered investment adviser.
The ETF units are issued in the new fund offer at a price that reflects the prevailing gold price. In the secondary market, the units trade at a price that reflects the net asset value (NAV) of the scheme and the demand and supply of units. Each unit typically represents one gram of gold. The ETF structure has an intermediary called the authorized participant who manages the liquidity by providing buy and sell quotes and managing the supply in the secondary markets such that the price reflects the underlying value of the units without too much variation. Despite this, not all gold ETFs have good liquidity in the secondary markets. Units of gold funds, on the other hand, are continuously available at the NAV-related prices from the mutual fund.
The returns in SGB and gold ETFs or funds will depend upon the appreciation or depreciation in the gold prices. The SGB also pays an interest on the initial investment at the rate of 2.5%.
“The additional return along with long-term capital gains (LTCG) exemption on maturity gives the bonds an edge over others," said Rego.
Gold ETFs can hold, along with physical gold, up to 50% of the portfolio in gold-backed financial instruments, which give exposure to gold without the storage costs of holding physical gold. This brings down the expenses in an ETF. “Relative to gold bonds, the returns from the ETF and gold funds will be lower to the extent of the interest income paid by the bonds and the expense ratio charged by the mutual fund," said Deepali Sen, founder partner, Srujan Financial Advisers LLP. Since the benefit of indexation on LTCG is available for both investments, the tax impact on returns will be minimal especially over longer investment horizons.
Gold ETFs and funds allow investors to accumulate units over time. “When you buy gold periodically, it helps average out the cost for the investor," said Sen. The low liquidity in the secondary market from SGBs means that investors may get to buy them only when there is an issue in the primary market, thus unable to take advantage of accumulating bonds at low prices.
The SGB has a tenor of eight years. One can exit after the fifth year on the interest payment dates at the prevailing market price. The bonds are also listed on the NSE and the BSE and can be sold in the secondary markets. However, the transactions on the exchanges are low and investors may have to sell at a discount. ETF investors can redeem units only by selling on the stock exchanges. The extent of liquidity in the units may impact the price. Units of gold funds, on the other hand, can be redeemed on any day at the prevalent NAV.
If you have an eight-year horizon, then SGBs are the best choice given the interest income and LTCG benefit. But, the investor should have the lump sum to invest in the primary issuances as accumulating them in the secondary market may not yet be a feasible option. If you want to accumulate gold in small tranches over a period of time, then gold funds and ETFs may be better. If you are accumulating to buy gold in future, the advantage of being able to lower the cost of acquisition by buying across time periods may outweigh the additional coupon income from bonds. Investors must consider the liquidity while selecting ETFs and the expense ratio of gold funds as these can impact its efficiency.