What Is a Government Security?
In the investing world, "government security" applies to a range of investment products offered by a governmental body. For most readers, the most common types of government securities are those items issued by the U.S. Treasury in the form of Treasury bonds, bills, and notes. However, the governments of many nations will issue these debt instruments to fund necessary ongoing operations.
Government securities come with a promise of the full repayment of invested principal at maturity of the security. Some government securities may also pay periodic coupon or interest payments. These securities are considered conservative investments with low risk since they have the backing of the government that issued them.
Key Takeaways
- Government securities are government debt issuances used to fund daily operations, and special infrastructure andmilitary projects.
- They guarantee the full repayment of invested principal at the maturity of the security and often pay periodic coupon or interest payments.
- Government securities are considered to be risk-free as they have the backing of the government that issued them.
- The tradeoff of buying risk-free securities is that they tend to pay a lower rate of interest than corporate bonds.
- Investors in government securities will either hold them to maturity or sell them to other investors on the secondary bond market.
Understanding Government Securities
Government securities are debt instruments of a sovereign government. They sell these products to finance day-to-day governmental operations and provide funding for special infrastructure and military projects. These investments work in much the same way as a corporate debt issue. Corporations issue bonds as a way to gain capital for buying equipment, funding expansion, and paying off other debt. By issuing debt, governments can avoid hiking taxes or cutting other areas of spending in the budget each time they need additional funds for a project.
After issuing government securities, individual and institutional investors will buy them to either hold until maturity or sell to other investors on the secondary bond market. Investors buy and sell previously issued bonds in the market for a variety of reasons. They may be looking to earn interest income from the bond's periodic coupon payments or to allocate a portion of their portfolio into conservative risk-free assets. These investments are often considered risk-free because when it comes the time for redemption at maturity, the government can always print more money to satisfy the demand.
Government securities come in a variety of forms, but the best-known types are the ones issued by the U.S. Treasury—Treasury bonds, bills, and notes.
The U.S. vs. Foreign Securities
As already mentioned, the United States is only one of many countries that issues government securities to fund operations. U.S. Treasury bills, bonds, and notes are considered risk-free assets due to their backing by the American government. Italy, France, Germany, Japan, and many other nations also float government bonds.
However, government securities issued by foreign governments can carry the risk of default, which is the failure of paying back the principal amount invested. If a country's government collapses or there's instability, a default can occur. When purchasing foreign government securities, it's important to weigh the risks, which can include economic, country, and political risks.
As an example of such default risk, one needs to look no further than 1998 when Russia defaulted on its debt. Investors were shocked by their losses as the country devalued the ruble. This downturn came on the heel of—and was in some part brought about by—the Asian financial crisis of the same decade. The Asian crisis was a series of currency devaluations by many nations throughout Asia that sent shock waves around the financial globe.
Although U.S. government securities or Treasuries are risk-free investments, they tend to pay lowerinterest rates as compared to corporate bonds. As a result, fixed-rate government securities can pay a lower rate than other securities in a rising rate environment, which is called interest rate risk. Also, the low rate of return may not keep up with rising prices in the economy or the inflation rate.
Buying Government Securities
The U.S. Treasury Department issues government securities through auctions to institutional investors for buying and selling. Retail investors can purchase government securities directly from the Treasury Department’s website, banks, or through brokers. Since most U.S. government securities have the full faith and credit of the U.S. government, default on these products is unlikely.
The purchase of foreign government bonds—also known as Yankee bonds—is a bit more complicated than buying the American version of the securities. Investors must work with brokers who have international experience and may need to meet specific qualifications. Some investors will assume the heightened aspects of political risk along with currency risk, credit risk, and default risk to reap the greater yields. Some bonds will require the creation of offshore accounts, and have high minimum investment levels. Also, some foreign bonds fall into the category of junk bonds, due to the risk attached to their purchase.
Controlling Money Supply Through Government Securities
The Federal Reserve (the Fed) controls the flow of money through many policies, one of which is the selling of government bonds. As they sell bonds, they reduce the amount of money in the economy and push interest rates upward. The government can also repurchase these securities, affecting the money supply and influencing interest rates. Called open market operations (OMO) the Federal Reserve (the Fed) buys bonds on the open market, reducing their availability and pushing the price of the remaining bonds up.
As bond prices rise, bond yields fall driving interest rates in the overall economy lower. New issues of government bonds are also issued at lower yields in the market further driving down interest rates. As a result, The Fed can significantly impact the trajectory of interest rates and bond yields for many years.
The supply of money changes with this buying and selling, as well. When the Fed repurchases Treasuries from investors, the investors deposit the funds in their bank or spend the money elsewhere in the economy. This spending, in turn, stimulates retail sales and spurs economic growth. Also, as money flows into banks through deposits, it allows those banks to use those funds to lend to businesses or individuals, further stimulating the economy.
Pros
Government securities can offer a steady stream of interest income
Due to their low default risk, government securities tend to be safe-haven plays
Some government securities are exempt from state and local taxes
Government securities can be bought and sold easily
Government securities are available through mutual funds and exchange-traded funds
Cons
Government securities offer low rates of return relative to other securities
The interest rates of government securities don't usually keep up with inflation
Government securities issued by foreign governments can be risky
Government securities often pay a lower rate in a rising-rate market
Examples of Government Securities
Here are some of the most commonly issued government securities.
Savings Bonds
Savings bonds offer fixed interest rates over the term of the product. Should an investor hold a savings bond until its maturity they receive the face value of the bond plus any accrued interest based on the fixed interest rate. Once purchased, a savings bond cannot be redeemed for the first 12 months it is held. Also, redeeming a bond within the first five years means the owner will forfeit the months of accrued interest.
T-Bills
Treasury bills (T-Bills) have typical maturities of 4, 8, 13, 26, and 52 weeks. These short-term government securities pay a higher interest rate return as the maturity terms lengthen. For example, as of Sept. 10, 2021, the yield on the four-week T-bill was 0.06% while the one-year T-bill yielded 0.08%.
Treasury Notes
Treasury notes (T-Notes) have two, three, five, or 10-year maturities making them intermediate-term bonds. These notes pay a fixed-rate coupon or interest payment semiannually and will usually have $1,000 face values. Two and three-year notes have $5,000 face values.
Yields on T-Notes change daily. However, as an example, the 10-year yield closed at 1.35% on Sept. 10, 2021. Over a 52-week range, the yield varied between 0.07% and 0.08%.
Treasury Bonds
Treasury bonds (T-Bonds) have maturities of between 10 and 30 years. These investments have $1,000 face values and pay semiannual interest returns. The government uses these bonds to fund deficits in the federal budget. Also, as mentioned earlier, the Fed controls the money supply and interest rates through the buying and selling of this product.
