The first Sovereign Gold Bond (SGB) issue of the fiscal year 2017-18 that is open from April 24th till April 28th has both macroeconomic and cultural significance. The macroeconomic significance is that it is being launched at a time when global geopolitical uncertainty is at a high. The war in Syria is getting messier and there is a lot of sabre rattling in North Korea. The geopolitical risk is more due to the fact that in both these wars; Russia and the US have massive stakes. Gold normally tends to outperform other asset classes in times of geopolitical uncertainty. The cultural significance is that the SGB issue will close exactly a day before the festival of Akshaya Trithiya. For the Hindus in India and across the world, buying gold during Akshaya Trithiya has a lot of sentimental value as it is considered to be a harbinger of prosperity during the year.
The SGB issue is being priced attractively…
The advantage that an investors gets in this SGB compared to physical gold is that it is priced at a discount. The government has priced this tranche of SGB at Rs.2901/gm as against the market price of Rs.2951/gm. Unlike in the case of physical gold, investing in SGB will also save you the hassles of storage and safety of gold. Similarly, if you buy gold in the form of jewellery, there is an additional making charge and each time you convert this into cash, there is a certain loss in translation. These risks can be entirely avoided when it comes to SGBs. Last, but not the least, the SGBs have the additional benefit of carrying a sovereign guarantee. Unlike other investment instruments, you need not worry about the default risk in an SGB. Al these factors add brownie points to the already attractive price at which the SGB is being issued by the government.
A better hedge against inflation…
It has been a long-standing debate on whether gold is a better hedge against inflation compared to other asset classes. There are no clear answers, but over a longer time horizon of 45-50 years, gold has managed to outperform inflation. Over a shorter time frame, there is no clear evidence of gold bettering inflation as gold prices have been quite volatile. The advantage that the SGB offers is that it also pays an interest of 2.5% per annum, which is payable in 2 tranches each year. This interest payout partially compensates for the inflation risk that you carry. Therefore, compared to physical gold and even Gold ETFs, these SGBs are better hedges against inflation. The icing on the cake is that this interest payment is also guaranteed by the government of India.
SGBs; to buy or not to buy at this point of time…
India and China continue to be the largest markets for gold in terms of jewellery demand. But the demand side has hardly driven gold prices in the past. At best, buoyant demand has helped to hold gold prices. The biggest bull-run in gold was seen between 1971 and 1980. This was the period of extreme geopolitical turmoil and included the Arab oil embargo, the Arab-Israel wars, the Iran-Iraq war and Russia’s invasion of Afghanistan. During this period, gold moved from $35/oz to $800/oz. The second sharp rally in gold prices was seen post the Lehman crisis in 2008. So what can drive gold prices now?
Firstly, geopolitical risk has shown signs of increasing in the last few weeks; both in West Asia and in South East Asia. This could lead to a gradual rise in demand for gold as a safe-haven asset. Secondly, gold prices have been lower in the last few months betting on tax reforms and infrastructure investments in the US. If that does not materialize to the extent anticipated it may lead to a revival in demand for gold. Lastly, gold is also emerging as an alternate currency. With most central banks printing money and infusing liquidity, most currencies have got debased on real terms. Gold could be a hedge against that. However, if global central banks start tightening liquidity, as early sound bites are indicating, gold may not exactly have a great rally from here.
So what should Indian investors do with the latest SGB issue?
While there are distinct merits in the SGB issue considering its pricing and its inherent merits, investors need to take more of a portfolio allocation approach to gold. From an asset allocation perspective, it is not advisable to allocate more than 8-12% of your overall portfolio to gold. You can tweak your gold holding within this range based on your outlook for gold. Investors need to remember that gold is a hedge against uncertain times. It is not an asset class like equity and equity mutual funds that will create wealth for you over the longer term. While SGB is a good product to buy, it is ultimately a proxy for gold. Hence your decision should eventually be driven by your overall allocation criteria.