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.

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

• Maturity – The maturity date varies depending on the type of bond. It could range from 365 days to over 30 years. For example, the US Treasury securities are classified into three types based on their length of maturity. Notes have a maturity of 1 to 10 years, and bonds have a maturity greater than ten years. Bills have a maturity of less than a year.
• Interest Rate – The interest rate could be fixed and floating. While the former grant fixed earnings, the latter varies as per the changing interest rates. Interest payments are made periodically at fixed intervals.
• Repayment – An investor receives the full-face value of the bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more if it is held until maturity.
• Inverse Relationship – The price of the bond and its interest rate have an inverse relationship. When the interest rate of a fixed-rate bond rises, its market price falls and vice-versa. For example, an existing bond has a 9% interest rate. If a similar bond is issued with a 10% interest rate, the former’s price will need to be reduced to allure buyers. This is because the investors would prefer splurging on the more attractive 10% bond. Hence, when the interest rate rises, the price falls.
• Trading – Most bonds can be traded in the secondary marketsSecondary MarketsA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more among investors after being issued in the primary marketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer.read more. An investor will still earn the prescribed interest rate if held until maturity. However, the price and interest rate changes will be felt upon selling it in the secondary market before maturity.
• Rating – Prices vary over the period because of multiple reasons. People prefer purchasing bonds with a high credit rating as it takes care of default risk. The bond is considered worth purchasing if the issuer holds a high credit rating (on credit analysis platforms, Moody’s, Standard and Poor’s, or Fitch).
• Yield – It determines the profitability of the security held by an investor. The yield can be calculated by dividing the annual coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more divided with the current price of the bond in the market. If a fixed-rate government bond’s interest rate increases, its price falls, lowering its yield. Also, due to the converse relationship between interest rates and bond prices, when the price rises, the yield falls.
• Types – Bonds are of different types suited to the risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more and needs of the investors. For example, fixed rate bondsFixed Rate BondsFixed rate bonds (FRBs) refer to debt securities, offering regular and fixed interest or coupon payments until their maturity. The interest rate and the expiration date are agreed upon between the issuer and the investor. As a result, FRBs pay a higher interest rate than the rest of the investment accounts.read more come with inflation risksInflation RisksInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.read more lowering yields as the rates aren’t adjusted to rising prices. To avoid this, some investors prefer Treasury Inflation-Protected SecuritiesTreasury Inflation-Protected SecuritiesTreasury inflation-protected securities (TIPS) are inflation-indexed bonds issued by the US government. Since its principal is indexed to the US consumer price index, it provides a hedge to the inflation risk. With increasing inflation, TIPS's principal values also rise, hedging the bond's inflation risk.read more (TIPS) to aim to cope with inflation by securing the actual value. This is achieved by indexing the principal amount to inflation or deflation daily.

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 and 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, the United States, and the United Kingdom. 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 serve as a benchmark for risk assessment of other securities. Some of the standard US Treasury securities are as follows:

• Treasury Bill- GT10:GOV is a ten-year bill. The securities’ price is $100.1 with an interest rate of 1.25% as of August 2021.
• The GTII20:GOV is a TIPS (Treasury Inflation-Protected Security). It matures in 20 years. The TIPS price is $152, with an interest rate of 2.13% as of August 2021.
• T-bills are sold in the money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more when the government wants to raise funds in a short period which makes them highly liquid. T-billsT-billsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more are sold at discount prices, but the government buys them back at full price, known as at-par price.

(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?

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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 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 

• An obvious advantage is a low risk, fixed earnings, and government protection. As such, they are an important source of pension funds.
• T-Bills are relatively liquid. The lowest time interval that you can buy bonds is 28 days. That’s not a lot of time, so your money still is relatively liquid if you need it shortly.
• When companies go bankrupt or lose a lot of their value, shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more take the losses first. Prioritized in the order of who gets paid first, if you are a bond-holder, you’re going to be paid first.
• Investment advisors suggest that bonds balance uncertainties in a client’s portfolio.
• The government shares every piece of information, whether it’s about fund utilization or other relevant data, with the public allowing transparency.

For the Government:

The state raises capital by issuing these bonds to pay 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 to 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 meager return on investment which may lead to inflation risk. The interest rate can be lower than 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 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

Recommended Articles

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

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• Treasury Bond