U.S. government bonds are considered very low risk investments because the likelihood of the U.S. government defaulting on its debt is commonly estimated to be near zero. Yields on U.S. Treasuries tend to be used as a key benchmark.
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 issue government bonds denominated in their own operating currency, or sometimes in the currency of another, often more stable, country.
Government bonds are redeemed at maturity, except it some cases where a government defaults on their debts. Russia in 1998, for example, defaulted on their debt rather than diluting the value of the Russian Ruble. 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
Government bonds usually have the following characteristics:
- Issue price: the price a bond is originally sold for 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, although this would normally be split into $25 semi-annual payments.
- 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 current supply and demand, with demand being dependent on factors including the level of other interest rate securities, and the expected strength of economy. If the economy is expected to enter a recession, bonds yields tend to fall, possibly allowing the Government to issue debt at lower interest rates than was previous.
If interest rates on newly-issued bonds are less than the coupon rate of an existing bond, then there will be increased demand for that existing bond, usually driving the bond price higher. If interest rates on newly-issued bonds are greater than the coupon rate of an existing bond, then demand for that existing bond will decrease in comparison, resulting in lower bond price until the bond yields line-up according to investor expectations.
Where To Buy Government Bonds:
From the U.S. Treasury in auctions held throughout the year on the TreasuryDirect website
Through a brokerage firm or bank
- Via a diversified 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:
- Bonds issued by the U.S. Government, and other highly credit-worthy countries around the world, generally provide lower expected rates of return than other investments such as commercial debt or equities. In some cases bonds may return less than inflation.
- Bond market values are sensitive to interest rates and inflation rates.
- There's still some degree of 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 the the interest rate levels at that time. If rates have risen since the bond was purchased, the bond is likely to be worth less than par value, 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 referred to as trading for a premium.
Brokers charge a commission when government bonds are sold on the secondary market.
Bottom Line
U.S. government bonds, as well as those issued by highly stable governments around the world, tend to be popular investments that are deemed to carry low risk of default. Such bonds share most of the same characteristics as corporate debt, except for the level of default probability, and in some cases taxation.
U.S. government bond yields are widely used as a benchmark and barometer for the health of the economy.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
