What Are Government Bonds & How Do They Work?
U.S. government bonds are low risk investments because it's very unlikely the U.S. government will default on its debt. However, due to its low risk, investors will not receive the same upside they would get for risky investments.
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Why Do Governments Sell Bonds?
Similar to individuals, governments borrow money by issuing government bonds. They use this borrowed money to fund spending. A countries' debt is called as sovereign debt.
Bonds are also issued by cities, towns, or regional or local governments to fund projects such as new libraries and parks, and they are called municipal bonds. Government bonds are classified as fixed-income securities because they earn a fixed amount of interest every year until the bond matures.
The first securitized bond appeared in 1517 when the Dutch Republic issued them to finance debt incurred by the city of Amsterdam. The first bond issued by a national government was in 1694 when England needed to raise money to fund one of its wars against France. To finance the American Revolution, the fledgling U.S. government-issued bonds that were called loan certificates, and they raised $27 million for the war effort.
How Do Government Bonds Work?
U.S. government bonds are known as Treasuries, while in the UK, they are known as gilts. The U.S. Department of the Treasury provides daily information on its Treasuries. Countries can issue government bonds denominated in their own currency, or in the currency of another, often more stable, country. Government bonds can be redeemed at maturity because the country can create additional currency in order to do so.
However, some countries, such as Russia in 1998, have chosen to default on their debt rather than create additional currency This was called the "ruble crisis" or the "Russian flu", and it resulted in the Russian government and the Russian Central Bank devaluing its currency the ruble.
Government Bond Characteristics
All government bonds have the following characteristics:
- Issue price: the price a bond is sold by an issuer
- Par or face value: the amount the bond will be worth at maturity. It also serves as the base amount on which interest is calculated on the bond
- Coupon rate: the interest rate of the bond, and is a percentage of the face value. If a bond has a coupon rate of 5% and a face value of $1,000, it will pay bondholders $50 every year, or $25 semi-annually
- Coupon dates: the dates when a bond issuer makes interest payments; most bonds pay interest semiannually
- Maturity date: the date on which the issuer will pay the bondholder the face value of the bond
- Current yield: equal to the annual coupon payment divided by the bond price.
Types of U.S. Treasuries
The types of U.S. Treasuries are:
- Treasury bills (T-bills): mature in less than one year, and their interest is recouped at maturity
- Treasury notes (T-notes): mature in 2, 3, 5, or 10 years and pay regular interest
- Treasury bonds, or T-bonds - have maturity dates between 10 and 30 years and pay regular interest
- Treasury inflation protected security, or TIPS - have interest rates that are adjusted semiannually to be in line with inflation rates, have maturity dates of 5, 10, and 30 years, and their par value increases with inflation and decreases with deflation according to the Consumer Price Index.
Like TIPS, the UK offers index-linked gilts, where the coupon rate changes with the UK Retail Prices Index (RPI).
How To Buy Government Bonds
Each government sets the number of bonds it wants to sell and the coupon rate it will pay. Then, their prices are determined by supply and demand, with demand being dependent on factors including the level of interest rates and strength of economy. If interest rates on newly-issued bonds are less than the coupon rate of an existing bond, then there is increased demand for that bond. If interest rates on newly-issued bonds are greater than the coupon rate of an existing bond, then demand for that bond will decrease.
Where To Buy:
From the U.S. Treasury in auctions held throughout the year on the TreasuryDirect websiteThrough a brokerage firm or bank
- Through a mutual fund or an exchange-traded fund (ETF)
Advantages and Disadvantages of Government Securities
Pros:
- U.S. bonds have a low risk of default.
- Provide a steady source of income, semiannually or annually.
- Are liquid, don't have to be held to maturity, and can easily be sold on the secondary market.
- Some Treasuries are free of state and federal taxes.
Cons:
- Generally provide lower rates of return than other investments such as equities. In some cases bonds may return less than inflation.
- Are sensitive to interest rates and inflation rates.
- Have default and currency risks.
- Income from foreign bonds is often taxed.
Interest earned from government bonds is subject to federal taxes but not state and local taxes. Interest on municipal bonds isn't subject to federal or state taxes so long as the investor lives in the state or municipality that issued the bond.
Bond Risk
While the U.S. has never defaulted on its government bonds, the same can't be said for bonds issued by other countries, especially those in emerging markets. Risk can be caused by a country's political situation, issues with its central bank, and the current state of its economy.
Another risk with buying foreign government bonds is currency risk, and it occurs if a foreign currency's rate of exchange to the U.S. dollar drops. Buying foreign debt denominated in U.S. dollars can eliminate this problem.
The Bond Secondary Market
After being issued, bonds are traded between investors in the secondary market. Unlike stocks, most bonds are not traded on exchanges, but rather are traded over the counter (OTC). Investors can buy and sell bonds through brokers or dealers.
The sales price of a bond sold before it reaches maturity is determined by current interest rates. If rates have risen since the bond was purchased, the bond may have to be sold below par, which is known as selling at a discount. Bonds trading at the same value as their face value are said to be trading at par, and if interest rates have fallen since the bond was purchased, the bond may sell above par, which is called selling at a premium.
Brokers charge a commission when government bonds are sold on the secondary market.
Bottom Line
Government bonds are a popular investment, especially for those who cannot incur the risk of losing principal. On February 10, 2022, yields on U.S. Treasuries jumped upward, with the yield on the 10-year bond gaining 12 basis points to reach around 2.05%. 1 basis point is equal to 0.01%. The yield on the 2-year Treasury bond increased by 26 basis points to 1.6%, making that increase the 2-year bond's largest single-day change since 2009. However, inflation in 2021 accounted to around 7% so a bond yielding 2% would have incurred a 5% loss in 2021.
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