What Are Government Bonds?

Government Bonds Explained

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A government bond is a debt security issued by a government to pay for services or other obligations. The issuer (government) promises to pay the lender (investor) a specified rate of interest during the life of the bond, which is called “the coupon.” The issuer also promises to repay the principal, sometimes referred to as “the par value” when it comes due at a predetermined date, which is the “maturity date.” This can be less than one year or longer than 20 years.

Bonds are safe ways to invest, but they do carry with them a certain level of risk. Learn what government bonds are, how they work, and their pros and cons.

Definition and Examples of a Government Bond

Government bonds are issued by the U.S. Treasury Department. There are different types of government bonds based on their maturities:

  • Treasury bills: Short-term government securities with maturities ranging from a few days to 52 weeks. Bills are sold at a discount from their face values.
  • Treasury notes: Issued with maturities between two and 10 years, and pay interest every six months.
  • Treasury bonds: Pay interest every six months and mature in 20 or 30 years.

Bonds issued by cities, towns, or regional or local governments are municipal bonds.

You can purchase bonds directly from the U.S. Treasury in auctions held throughout the year, or through a brokerage firm or bank. Another way to invest in bonds is through mutual funds or exchange-traded funds (ETFs).

How Government Bonds Work

Governments receive revenue through taxes, which are used to pay for health services, infrastructure, security, and other services. When they do not have enough money to cover their expenses or need to pay for a specific project, they can issue bonds to help cover the cost.

Investors purchase government bonds because they provide a predictable and steady income stream, and they are generally considered a low risk in terms of protecting the original amount invested. The trade-off for this low volatility is a risk that market interest rates may increase, leaving bondholders with bonds that are not paying as much interest as bonds that have been issued more recently. In other words, the bond yield—the coupon rate divided by the face value of the bond—decreases. That matters mostly if you want to sell the bond before its maturity date.

If market interest rates drop, a bond purchased earlier with a higher coupon rate will become more valuable on the open market. For example, if an investor buys a Treasury bond offering a 3% coupon and one year later, the market interest rate drops to 2%, the bond with a 3% coupon rate becomes more valuable than newly issued bonds paying 2%. If the investor sells the bond before its maturity date, the price will likely be higher than it was a year earlier when newly issued bonds also were paying 3%.

U.S. vs. Foreign Government Bonds

Just as you can buy shares of stock in foreign companies, it is possible to buy bonds issued by foreign governments (and foreign companies). This is one way to diversify an investment portfolio.

Like the U.S. Treasury’s bonds, international bonds pay interest semiannually or annually. However, international bonds are thought to be riskier than U.S. Treasury bonds, particularly those issued by emerging market countries.

One reason is that purchasing foreign government bonds exposes an investor to currency risks—the possibility that the rate at which the foreign currency exchanges to the U.S. dollar drops. Additional risks include credit and default risk (U.S. Treasury bonds have almost no default risk), liquidity risk, and interest-rate risk.

Pros and Cons of Government Bonds

Pros
  • Low risk of default for U.S. bonds

  • Provide a steady source of income

  • Accessible

  • Liquidity

  • Some bonds have tax advantages

Cons
  • Relatively low rates of return

  • Interest-rate risk

  • Default and currency risk

  • May not keep up with the rate of inflation

  • Taxes on foreign bonds

Pros Explained

  • Low risk of default for U.S. bonds: Bonds issued by the U.S. government are considered to have almost no risk of default.
  • Provide a steady source of income: Bonds provide a predictable source of income through semiannual or annual interest payments.
  • Accessible: Bonds can be purchased directly from the U.S. Treasury or through a brokerage firm or bank. Many investors purchase bonds through mutual funds or ETFs.
  • Liquidity: Bonds do not have to be held to maturity and can be easily sold on the secondary market, although not always at a profit.
  • Some bonds have tax advantages: Some U.S. Treasury bonds are free of state and federal taxes.

Cons Explained

  • Relatively low rates of return: The “low risk, low return” mantra holds true most often with bonds, especially when compared to stocks.
  • Interest-rate risk: If market interest rates increase, a bond that pays a lower interest rate will be worth less on the secondary market.
  • Default and currency risk: Bonds issued by foreign countries may expose an investor to risk through a country’s political or economic instability as well as fluctuations in currency exchange with the U.S. dollar.
  • May not keep up with the rate of inflation: Bond returns may fall behind the rate of inflation.
  • Taxes on foreign bonds: Income from foreign bonds are often taxed.

What It Means for Individual Investors

Government-issued bonds can be an effective way to lower the risk of an investment portfolio. Income investors appreciate the predictable stream of income generated by government bonds. However, it is important to pay attention to market interest rates to determine if your coupon rate is keeping pace with inflation. If necessary, you can work with an investment adviser to assess your options if a bond is losing value.

Key Takeaways

  • Government bonds are issued by governments to pay for services or other obligations.
  • The issuer promises to pay the lender a specified rate of interest during the life of the bond through annual or semiannual payments. This is called “the coupon” or “coupon rate.”
  • Bonds issued by the U.S. Treasury are considered to be low risk. Foreign government bonds may pose higher risk if there is political unrest or fluctuations in the currency exchange.
  • Bonds can be purchased directly from the U.S. Treasury or through a brokerage firm or bank. They can also be purchased via mutual funds or ETFs.
  • Bonds come with maturity dates ranging from less than one year to 30 years. However, U.S. bonds are relatively liquid and can be sold on the secondary market before the maturity date.