Are state-government bonds risk-free?

IME Capital Investment Queries provide answers to common investor queries that are directly written by IME Capital’s Central Investment Team. This helps ensure centralised, common and transparent communication of our thoughts to all investors (& potential investors) of IME Capital, and helps mitigate against the disparate communication common in the wealth management industry.

Written by IME Capital’s Investor Desk on June 15, 2022

Investors often view state government bonds, to be very low-risk, given the fact that they are backed by the government. Out here, it is important to understand the difference between a central government bonds & the state government bond.

The central government technically has the power to ‘print money’ (via the RBI), and it is therefore assumed that default risk is extremely low. If the central government is running out of money, they can simply print more to repay outstanding local debt (this may have implications on currency, interest rates etc.). However, if the central government has large outstanding foreign currency loans, there does exist the clear risks of a default (since printing money can lead to large currency devaluations, and the debt needs to be repaid in a foreign currency).

A state government on the other hand, does not have the power to ‘print money’. If a state government gets into a cash flow crunch, a default is a real risk. Often, the central government may step in to bail out a state government, but this may not always be the case. This is why state government bonds, do carry clearly higher credit-risk compared to a central government bond, and why the bonds of state governments offer higher yields than central government bonds (to cover for the higher risk of default).