Government Bond

Government Bond Definition

A government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income. The government uses these funds for welfare schemes, capital project financing, operating expenses and other financial obligations.

They are considered a safe investment as the sum collected is not invested in the stock market. Instead, it is distributed across projects and spending requirements of the government.

Key Takeaways

Government Bonds Explained

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By buying government bonds, the investors loan money to the US government. In exchange, they get a defined rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more known as the yield. The length of time for the investment is known as the maturity. Once an investor purchases a bond, the investor receives an interest income in regularly scheduled payments until the bond matures. At maturity, the government pays back the total amount invested which can also be called the principal.

The government utilizes the debt to finance its spending requirements. For example, the US Treasury’s job is to raise money for government expenses and pay the nation’s bills. While levying taxes is one of the ways to raise funds, another route is through the issue of bonds to investors in the open market.

As for the investors, the government’s backing makes them a relatively safer investment, unlike stocks that are highly prone to market fluctuations. Usually, the investment come with low risks and low but steady gains. So let us take a look at some of its traits.

Features of Government Bonds

Examples

  • A purchased a 10-year bond in 2000 from the Federal National Mortgage Association. The maturity was due in 2010. In 2008, there was a mortgage crisis and the association fell into distress. It was expected to default. Yet, A’s investment was safe as the federal government stepped in and guaranteed the principal along with interests.
  • Let us look at another example to understand the short-term usage of bonds. Say, R buys a $100 Treasury bill at an auction for a discount price of $99.86 on Day 1. 4 weeks later, the government pays him the full $100. R has made a profit of $0.14.

Real-World Examples

US government bonds

Government bonds are issued worldwide, including in Canada, Australia, India, United States and the United Kingdom, among others. In the US, government bonds are known as Treasuries. They include notes, bills, bonds and Treasury inflation-protected securities (TIPS). Treasuries are highly credible and, therefore, serve as a benchmark for risk assessment of other securities. Some of the standard US Treasury securities are as follows:

(Coupon rates source: Bloomberg)

UK Government Bonds

In the UK, bonds are also acknowledged as gilts. Let’s take a look at two of them below.

  • The GTGBP2Y: GOV is a UK Gilt 2 Year Yield. The price of this short-term gilt is €100.02 with a 0.13% interest rate as of August 2021.
  • The GTGBP30Y: GOV is a UK Gilt 30 Year Yield. The price of this long-term gilt is€92.18 with an interest rate of 0.63% as of August 2021.

(Coupon rates source: Bloomberg)

How to Buy Government Bonds?

government bonds how to buy

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The government auctions the bonds where financial institutions largely participate. Auctions are also open to the general public. The financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more then sell these bonds to banks, pension funds, and individuals. Individuals can acquire bonds from the financial institutions with the help of brokers.

Investors can also buy them directly from the government. For example, using the TreasuryDirect account, individuals, trusts, corporations, estates, etc., can directly purchase Treasury securities from the US government. It is an account where one can purchase and hold the security. The picture above describes how an individual can acquire these bonds in the US.

Like stocks, bonds issued in the primary market, also trade in the secondary market, primarily in over-the-counter (OTC) exchanges. Here investors buy and sell bonds. Exchange-Traded FundsExchange-Traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange.read more (ETFs) and mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more are other options to buy bonds when they are a part of the portfolio.

Uses

Government bonds are valuable for the government, investors, and economy in the following ways.

For investors 

For the Government:

By issuing these bonds, the state raises capital for paying off its operational and capital expendituresCapital ExpendituresCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more. Many of the large-scale projects, as well as infrastructure development costs, are financed using bonds.

For the Economy:

A country’s central bank considers bonds a crucial tool for regulating the money supply. Bonds play a crucial role in curtailing inflation or deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more. The US Federal Reserve usually repurchases them to facilitate the availability of cash with the public.

As part of quantitative easing to lower deflation, countries also indulge in large scale buying of bonds to infuse more money into the economy. Sometimes, they lower long-term bonds’ yield or interest rates to make stocks more appealing to investors. With large-scale buying of stocks, the market starts to boom, helping address deflation.

Disadvantages 

The major shortcoming is the meagre return on investment which may lead to inflation risk. The interest rate can be lower than the inflation. Let us assume that A spent $95 on a 1-year bond in 2000. At the end of the year, he receives $100. The inflation that year was 10%. So, the $100 in 2001 is worth only 90 US dollars from 2000. As a result, A incurred a loss of 5 %.

Default risk is another risk if the issuer fails to repay the debt. Finally, interest risk puts a fixed-rate holder in a loss occurring due to differences in changing rates of newer issues.

FAQs

What is a government bond?

A government bond is a debt instrument that provides an interest income at a specified rate. They are considered safer compared to stocks as the government issues them for funding requirements. Investors lend their money to the issuing body and earn an interest income in return. Upon maturity, the principal amount is repaid.  

How does a government bond work?

One can buy a government bond directly from the government, brokers, auctions or through financial institutions. The interest is paid periodically, typically semi-annually. If held until maturity, the issuer will repay the principal amount. For example, $1000 invested in a 10-year bond at a 5% rate yearly would pay an interest of $50 annually and $1000 at the end of 10 years.

What are examples of government bonds?

An example is those issued by the US Treasury. They are classified into three types based on their length of maturity. Bills have a maturity of less than a year. Notes have a maturity of 1 to 10 years, and bonds have a maturity of greater than ten years. 

This has been a guide to Government Bonds. Here we discuss its definition, key takeaways, features, practical and real-world examples, how to buys government bonds, uses and disadvantages. You can learn more about accounting from the following articles –

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