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Government Bonds

What Are Government Bonds?

Bonds are debt instruments issued by governments to the public. Essentially, when a government sells bonds, it's borrowing money to finance its activities, including infrastructure projects, health and welfare benefits, defense expenditures and the like. It also sells bonds to pay off its previously issued debt—in other words, selling new debt to retire old debt.

The United States government bond market is the largest debt market in the world. According to recent figures, the U.S. Treasury had over US$23 trillion of public debt outstanding, of which more than US$17 trillion was held by investors, including individuals, financial institutions, insurance companies, mutual funds and pension funds. The remaining US$6 trillion or so is held by entities of the U.S. government, most of which is held by the Social Security Administration and the Federal Reserve.

Maturities

The U.S. government sells a wide variety of debt securities in various maturities, ranging from one month to 30 years, on a regularly scheduled basis. Technically speaking, U.S. government debt instruments that mature in a year or less are called Treasury bills; those maturing from one year to 10 years are called Treasury notes; and anything maturing longer than 10 years are called bonds. However, the entire structure is collectively called the government bond market.

Bills are sold in maturities of four, eight, 13, 26 and 52 weeks. Notes are sold in maturities of two, three, five, seven and 10 years. Bonds are sold with 30-year maturity dates, although the Treasury has been exploring selling 50-year bonds. U.S. Treasury securities are sold in denominations of US$1,000.

U.S. government bonds are often called "Treasuries" or "guvvies" by people in the business.

Interest Payments

Investors who buy government securities receive interest, either on a quarterly basis or when the bonds mature, depending on the type of bond issued. They get their money back when the security matures.

For example, investors in the Treasury's 10-year note—one of the most popular maturities—receive quarterly interest payments while they hold the security. Those interest payments are often called "coupons," because in the days before computers and electronic investment holdings, investors received paper bonds that included detachable coupons that corresponded to each quarterly interest payment.

At the end of each quarter, the investor detached that quarter's payment and took it to the bank to receive the payment. Today bonds are almost always issued and held electronically, usually at the customer's brokerage firm or bank or in their account at the Treasury, if they have an account there.

For example, if an investor owned a US$10,000 10-year note that carries a 2% annual interest, or coupon rate, they would receive US$200 a year in interest, or US$50 quarterly. When the note matures, they would get their US$10,000 back. So, if they held the note until maturity, they would have received US$2,000 in interest over the life of the note.

The U.S. also sells Treasury inflation-protected securities, called TIPS, in which the coupon rate fluctuates with the level of inflation.

Are Government Bonds Risk-Free?

Generally speaking, Treasury bonds are considered to be risk-free in terms of credit risk, because the chances of the U.S. government defaulting, or not being able to pay its debt, are almost inconceivable. Indeed, the interest rate on Treasury securities is called the "risk-free rate," against which the investment returns on securities of a comparable maturity are compared.[2]

Unlike just about any other debt issuer on the planet, the U.S. government can always borrow additional money to pay off old debt, which it already does on a regular basis. Also, it can simply print more money if it had to. So investors can rest assured that they will receive the interest due them and get their money back when the bond matures. That said, government bonds, like all bonds, do bear other types of risks.

Interest Rate Risk

Government bonds are subject to interest rate risk, which could affect the bond's value, or price, over time. When the Treasury first sells a bond, it is usually sold at "par value" or "face value," equal to 100. For example, in our previous example, a US$10,000 note with a 2% coupon rate is worth US$10,000 on the date of issuance. However, once the note is sold, the price of that note can change depending on the general level of interest rates in the financial markets.

For example, let's say an investor paid US$10,000 for that 2% note, but about a month later the general level of interest rates for 10-year notes had risen to 2.2%. Quite obviously, that 2% note is now worth less than it was previously, because an investor would not be willing to pay the same amount of money for a bond paying 2% when they could get a bond paying 2.2% elsewhere.

If the investor holding that 2% note had to sell their note before it matured, they would have to reduce the price to get another investor to buy it, maybe US$9,950. As a result, they would have lost US$50 on his bond investment. Again, this would only be the case if they had to sell it prior to maturity.

This also works the other way. If interest rates dropped after the bond was issued, it would likely become more valuable, and its value would rise above US$10,000.

Professional bond traders make their money by buying and selling bonds when the prices move up and down. Long-term investors tend to care more about receiving the regular interest payments.

Inflation Risk

Bonds can lose value if the level of inflation rises while the investor is holding the securities. While not perfectly correlated, interest rates on government bonds tend to track the generally perceived level of inflation in the economy. With that in mind, a 2% interest rate on a 10-year bond would imply that people expect inflation to be 2% a year over that time.

However, if inflation began to surge above that level, the price of that 2% bond would likely fall, just as it would if interest rates started to rise. The bond would lose its appeal, and its price would decline. If inflation expectations fell, then the bond's price would likely rise. Inflation-indexed bonds like TIPS can help mitigate this risk.

Supply And Demand

Simple supply and demand pressures for government bonds also affect interest rates and thus bond prices. For example, if the government is running big budget deficits or planning to spend a lot more money on new programs, and thus needs to sell more debt than normal, that new supply of bonds could depress existing bond prices and put upward pressure on interest rates.

Currency Risk

Foreign investors who buy securities denominated in another currency incur currency risk. For example, an investor in the U.K. who buys a U.S. Treasury bond and later sells it after the pound has weakened against the dollar may get less money for it in pound terms even if the price of the note has risen in dollar terms in the meantime. Conversely, if the pound strengthened, they may record a currency gain.

Advantages Of Government Bonds

Because they have virtually no credit risk, U.S. government bonds are considered one of the safest investments around. Indeed, during times of market and financial stress, investors often buy Treasury securities as a "safe haven."

In addition to their safety, government bonds have other advantages. Interest on Treasury bonds is exempt from state and local taxes in the U.S., although it is subject to federal taxation. However, if an investor makes a profit by selling a bond for more than what they paid for it, they may be subject to federal and state capital gains taxes.

Treasury securities are highly liquid and are easily bought and sold through banks and brokerage firms, both new issues and older ones. There is a large, active secondary market for virtually all Treasury bond maturities. Indeed, the government bond market is one of the largest markets in the world.

Investors can buy and hold all types of Treasury securities directly from the government through its TreasuryDirect website. However, investors can't sell securities through the site.

Summary

The U.S. government bond market is one of the largest financial markets in the world, totaling about US$23 trillion, of which US$17 trillion is held by investors. The Treasury Department funds government operations through the sale of debt of various maturities.

Government bonds are generally considered to be "risk free" because of the unlikelihood that the U.S. government will ever default on its debt. However, they are subject to other types of risk, including interest-rate risk and currency risk.