Sep 03, 2020
So you have decided to buy Sovereign Gold Bonds. And you want to look for deals in the secondary market to see which Sovereign Gold Bond provides you the most value. We cannot calculate an absolute yield for this instrument, since we do not know the gold price at maturity in advance. We try to derive a fair value instead. This provides us with a means to compare value across Sovereign Gold Bonds.
We do not know the Gold price at maturity, so let us assume that the gold price remains constant for the entire duration. The aim here is to do a relative comparison of Sovereign Gold Bonds to find the best value as of this day. It does not matter what gold price you choose, as long as you use the same price to calculate a fair value for all Sovereign Gold Bonds.
Sovereign Gold Bonds provide two types of income, a periodic interest income and a value equal to the gold price difference between your holding period.
The interest component is on the face/nominal value of the bond. This is the price the Sovereign Gold Bond was originally issued at. The interest income is fixed for a given Sovereign Gold Bond and does not fluctuate with gold price changes. For example, A 2.5% interest on an INR 5000 face value would get you INR 125 in two equal installments per year till maturity. Since this is guaranteed money, it should count towards fair value calculation.
Assuming, five years to maturity and an INR 200 interest per year, we are going to make INR 1000 cumulatively over five years. The value of money fluctuates over time (mostly depreciates). It would therefore be unfair to compare cumulative returns of various Sovereign Gold Bonds that have different maturities. We could instead figure out "how much is all that future money worth today?". In financial terms, we calculate the present value of all future cash flows. Check out the PV formula in Microsoft Excel to understand this a bit more.
Accrued Interest is referred to as the interest that investment is earning, but which hasn't been paid yet. The interest adds up (accrues) every day, but is paid only every 6 months. A seller of the bond adds the accrued interest to the price while selling. The Sovereign Gold Bonds prices implicitly also account for accrued interest. The buyer ends up paying the seller this interest in the price of the bond, so we have to remove it from the fair value.
Fair Value = Current Gold Spot Price + Present Value of all the future interest cashflows - Accrued Interest
The fair value depicts the guaranteed value we make out of a Sovereign Gold Bond if the Gold price remains constant.