A government bond is a debt security issued by a government to support government spending and obligations. These bonds can pay periodic interest payments, known as coupon payments. Government bonds issued by national governments are often considered low-risk investments since they are backed by the government.
Government bonds issued by federal governments are also known as sovereign debt.
Key Points
- Debt Investment: A government bond represents debt issued by a government to support spending.
- Interest Payments: Some bonds pay periodic interest, while others are sold at a discount with no coupon payments.
- Low-Risk Investment: Backed by the government, making them lower-risk compared to other securities.
- Variety in U.S. Bonds: Different types of U.S. Treasury bonds are considered among the safest investments globally.
- Lower Interest Rates: Their comparatively low-risk profile results in lower interest rates.
Understanding Government Bonds
Governments issue bonds to raise money for projects or day-to-day operations. In the U.S., the Treasury Department conducts auctions to sell these bonds throughout the year. Investors, usually large banks, buy U.S. government bonds directly at auction. The auction process involves buyers submitting purchase bids until all bonds are allocated.
Some Treasury bonds trade on the secondary market, allowing individual investors to buy and sell previously issued bonds. Investors can use financial institutions, brokers, or opt for exchange-traded funds (ETFs) that encompass a basket of securities to participate in this market.
Risks and Considerations
Fixed-rate government bonds can carry interest rate risk when rates increase, causing the value of existing lower-yield bonds to decrease. Also, not all government bonds account for inflation, leaving investors vulnerable to rising prices within the economy.
Municipal Government Bonds
Local governments issue municipal bonds, or “munis,” to fund public works like infrastructure, libraries, or parks. These bonds often come with tax advantages and exemptions.
Municipal bonds can be considered as loans from investors to local governments for various public works projects, funded either by local taxes or revenue from the projects. While they have lower interest rates than corporate bonds or stocks, they offer stability and low default rates.
Bond Terms to Know
Familiarize yourself with essential terms related to government bonds:
- Face or Par Value: The debt amount loaned to the government, which is returned at bond maturity.
- Coupon: The regular interest payments made to bondholders.
- Yield: The interest rate of the bond after accounting for its market price.
- Market Price: The bond’s price in the secondary market, which may differ from the face value.
- Treasuries: U.S. federal government bonds.
- T-Bill: Short-term Treasuries maturing in one year or less.
- T-Note: Medium-term Treasuries with maturities ranging from 2 to 10 years.
- T-Bond: Long-term Treasuries with maturities of 10 to 30 years.
- TIPS: Treasuries indexed to inflation.
U.S. vs. Foreign Government Bonds
U.S. Treasuries are nearly risk-free investments as the issuing government backs them. Due to their low-risk profile, Treasuries yield lower returns compared to equities and corporate bonds. Conversely, government bonds from emerging markets carry higher risks such as country and political instability, as evidenced during the Asian financial crisis of the late 90s.
Uses of Government Bonds
Government bonds fund deficits, raise capital for infrastructure and other projects, and help control the nation’s money supply through Federal Reserve activities.
Pros and Cons
Pros
- Steady interest income.
- Low risk of default (especially for U.S. bonds).
- Exempt from state and local taxes.
- Highly liquid market for reselling.
- Accessible through mutual funds and ETFs.
Cons
- Lower rates of return.
- Fixed income might not keep pace with rising inflation.
- Prone to interest rate increases.
- Additional risks in foreign bonds.
Examples of U.S. Government Bonds
Various bonds issued by the U.S. Treasury include:
Savings Bonds
Series EE and series I savings bonds sell at face value and offer fixed interest rates while doubling when held for 20 years.
Treasury Notes
Intermediate-term bonds maturing in two to ten years, with fixed coupon returns and face values typically set at $1,000.
Treasury Bonds
Long-term bonds with maturities from 10 to 30 years, providing semi-annual coupon payments. They help mitigate shortfalls in the federal budget.
Treasury Inflation-Protected Securities (TIPS)
These bonds are indexed to inflation and adjust par values based on price increases or decreases in the economy, offering a hedge against inflation.
Buying vs. Trading Bonds
Holding bonds until maturity ensures coupon payments and the return of principal, though market prices can fluctuate in the meantime. Bond trading strategies include benefiting from yield spreads and yield curve differences.
Buying Government Bonds
U.S. Treasury securities can be purchased through brokers or directly via the TreasuryDirect website. Municipal bonds are available via brokers.
Understanding Government Bonds’ Interest Rates
Government bonds have lower interest rates due to their near-riskless nature. The U.S. government has never defaulted, assuring a lower yield but stable income for investors.
Conclusions
Federal government-issued bonds are among the safest investment types, offering the risk-free rate of return. Though they carry lower yields, they provide stability. Treasuries cover short-, medium- and long-term bonds, while foreign governments also issue bonds globally with different risk profiles. State and local governments issue municipal bonds with potential tax advantages.
Related Terms: stocks, corporate bonds, interest rates, inflation, fixed income, emerging markets.
References
- U.S. Department of the Treasury, FiscalData. “Debt to the Penny”.
