Recently, I saw a popular post on X which got my eyeballs rolling. It was a table containing the comparison of the returns of various gold investing options.
Source: This image was shared in X by user Rahul_J_Mathur who credits the source of the snap to user BahlKanan.
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At first, I was totally baffled seeing this table… yep... totally. I would tell you the reason in the subsequent paras but before that I wanted to check the calculations. Are they correct? Are the assumptions reasonable? I checked and the numbers, calculations, and the assumptions, all seemed to be true. In short, the table is legit.
But what is the problem with the table? Why write this post? I am coming to it.
You see, the difference between the two numbers in the table seemed totally off to me … 6.79% the return on physical gold jewelry, and 11.82% the return on SGBs, a whopping 5.03% difference between these two. But the numbers were correct, and numbers don’t lie, so the difference must be justified in some way, right? Or is it not?
Why shouldn’t there be a huge difference between these two you ask, well, let me come to the point. To do so let’s discuss a few points on SGB first.
What are SGBs?
According to the RBI, “SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity. The Bond is issued by Reserve Bank on behalf of Government of India.”
In essence, SGBs are derivatives with the underlying…, you guessed it right… gold!
And this is why there should not be such a significant difference between the returns of gold jewelry and that of the SGB. The returns of derivative and its underlying asset cannot have such a deviation. If all the above options allow you to effectively invest in the same one single asset class i.e. gold, then their returns should also be similar, right?
In a unified market, this price differential leads to what we call in finance as ‘Arbitrage.’ Every person who is positive on gold for the long term would sell physical gold (as the returns are lower) and buy SGBs (where the returns are higher.) This would continue as long as the returns on both these investment options stabilize and reach an equilibrium. In free market, theoretically, arbitrageurs should have stepped in and have nullified this price differential.
Wait! Wait! There is more! The word to be emphasized here is theoretically!
What if I told you among all these investment routes, SGBs have been designed to ensure that such an arbitrage opportunity does not exist? Let’s come to some practical and more technical aspects.
You see, the return on physical gold is lower than that of SGB because of one single reason – tax. Both through Direct and Indirect Tax. The government is at play here.
First, let us leave out the locker charges of INR 16,000 as gold worth INR 1 Lakh can be stored in homes and as the investment becomes greater and greater the locker charges become more and more a tiny percentage of the total value.
Let us also leave out the making charges – as it changes from individual to individual and there is the benefit of physical convenience i.e. you could wear them to your favorite events and occasions. The glittering physical gold jewelry is visually appealing and is a status symbol to further your opportunities. To put it simply, making charges as a cost is excluded because the person pays for the display utility that comes with it.
Now that the true cost and non-financial benefits have been factored in, let us calculate the CAGR on physical gold. It is now 9.87% from the previous 6.79%. There is still some difference between the returns, which as explained is because of taxation. The return to the SGB holder over the physical gold is effectively from the tax benefits and the interest. But why does the government pay a 2.5% interest?
According to the first principles of finance, return and risk follow each other. Greater the return, greater must be the risk. What are the reasons behind the extra return in SGBs? This is mainly because of three reasons,
one – The SGBs are only partially liquid, because if they are sold before maturity, the tax benefits are taken away! The tax benefits (read returns) are essentially tied to the holding period; thus, impacting the liquidity options of the holder.
two – the government wants to move investors from the unorganized segment to the organized segment.
three – as described by the RBI, SGBs are essentially government securities and thus they carry all the risks that any other G-Sec carries. To highlight one of them, physical gold stored at home is one of the rare accessible assets that has zero political risk compared to SGBs that carry political risk. This is because in case of SGBs, you trust the RBI to hold the gold for you. Though, in the Indian context, this political risk is very minimal.
Thank you for reading this article. Hope to have added some value to you!
The aim of this article is to try and explain the intricacies of finance through SGBs and is not an investment advice.
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