sovereign gold bonds, not colored

I have already displayed my dislike for gold for investment purposes; I don't like it for decoration either; wasteful altogether.  It is like when there is demand, supply shouldn't stop. To say that Indians are fascinated with the yellow metal is an understatement, what with 1000 tons of annual consumption. In a country where foreign exchange is precious, the dollar spend on gold never ceases. There isn't any appreciation for the lost opportunity; and the cost is massive.

After the government came out with the sovereign gold bonds, has the equation changed for gold buyers? The short answer is: No for those who love decoration; and may be for others. 

Before we go further, here's the brief.

• Bonds held in demat form and traded on the exchanges.
• There will be no physical gold.
• Time to maturity is 8 years.
• Interest is paid semi-annually on the investment at 2.75% pa, which is taxable.
• Redemption proceeds are calculated based upon units held at the prevailing market price.
• Capital gain on maturity is not taxable; before maturity is taxable.
• Minimum investment is 1 gram and maximum is 500 grams.
• Units held are protected; however, there is no protection against capital loss due to price fall.

At least there is no physical trace of gold; and with no foreign exchange involved makes it interesting. The government is not going to deliver gold upon maturity; all that is involved is, cash in and cash out. There isn't any yellow to be seen; and this might make the majority of Indians go gaga. Never mind, the few remaining will have reasons to think more rationally. 

These bonds are sort of derivative instruments, whose price would change based upon the price of the underlying, i.e. the gold. How likely are these prices to go up? If history is any indication, there might be a little scope to make these bonds good enough. From 1969-2012, the prices increased by 9.25% annually; from 1992-2012, 7.77%; from 1997-2012, 10.15%; from 2002-2012, 17.91%; from 2007-2012, 17.85%; and from 1969-2005, the prices increased by 7.57%; however, from 1980-2012, it was -(0.55)%. What is our fallback time period?

Now that the new tranche of September 2016 is coming up, the investor's prime concern should be where the prices would be in September 2024; and then marginal tax rate of the investor; all the rest can be safely ignored. The gold price for the September 2016 investment is fixed at Rs.3,150 per gram.

In the last 7 years, gold prices have increased annually at 10.65%. If this is any indicator, the bonds are going to be fabulous. Alas, that may not be the case; that is called the risk in the game.

Whether these bonds are any good for investment purposes depends upon the expectations of the investor. 

Let's start with the base rates. If the alternative is to keep the cash in bank deposits, the opportunity cost is about 7.25%; the long term government bonds trade at 7.12% today. This is the pretax rate of return. Since capital gains on the bonds are tax free, we need after-tax rates. For someone who is at 20% tax, the after-tax rate of return is 5.70%. 

So how much the gold prices will have to increase for the bond investor to match the government bond rates?

For someone who is in 0% tax rate, it is going to be 4.78%. That is to say, the gold prices will have to increase from Rs.3,150 to Rs.4,238 per gram by September 2024. 

For the 20% tax rate investor, the gold prices will have to increase by 3.78% annually until September 2024 to match the government bond rate of return.

Since I believe that investment in gold is based upon the greater fool theory, gold prices can be anywhere in September 2024. For each, the hunch is unique; yet, the hunch it is. 

For the 30% tax rate investor: If the price remains at Rs.3,150 in 2024, the rate of return will fall to 1.92%. To make it a little more interesting, to get 0% return (i.e. just the capital is protected) over the 8-year period, the gold prices will have to fall by 2.07% to Rs.2,665 per gram.

The gold bond investor would obviously expect more than the government bond rates. What if the investor expects 10% after-tax return?

Well, the investor at 25% tax rate would have to see the gold price increase by 8.46% annually over the 8-year period to get 10% after-tax return on cash flows. I come back to the hunch.