Government Bonds Definition
How Government Bonds Work
U.S. Government Bonds vs. Foreign Government Bonds
Advantages and Disadvantages of Government Bonds
What Does This Mean for Individual Investors
Definition of Government Bonds
Government bonds are debt instruments issued by the government to fund services or other obligations.
Government bonds are issued by the U.S. Department of the Treasury. There are different types of government bonds based on their duration:
- Treasury Bills: Short-term government securities that range from a few days to 52 weeks. These bonds are sold at a discount to their face value.
- Treasury Notes: Issued with maturities ranging from two to 10 years, paying interest every six months.
- Treasury Bonds: Pay interest every six months and mature in 20 or 30 years.
Bonds issued by cities, towns, or local or regional governments are known as municipal bonds.
You can purchase bonds directly from the U.S. Department of the Treasury during auctions held throughout the year, or through a brokerage firm or bank. You can also invest in bonds through mutual funds or exchange-traded funds (ETFs).
How Government Bonds Work
Governments receive revenue from taxes, which are used to pay for healthcare, infrastructure, security, and other services. When they do not have enough money to cover their expenses or need to fund a specific project, they can issue bonds to help cover the cost.
Investors buy government bonds because they provide a predictable, steady income and are generally considered low risk in terms of protecting the amount of the principal invested. The trade-off for this low volatility is the risk of rising interest rates in the market, which leaves bondholders with bonds that pay interest at a lower rate than newly issued ones. In other words, the yield on bonds – the interest rate divided by the bond’s face value – mainly matters if you plan to sell the bond before its maturity date.
If market interest rates decline, a bond purchased earlier at a higher interest rate will become more valuable in the secondary market. For example, if an investor buys a Treasury bond offering an interest rate of 3% and after one year, the market interest rate drops to 2%, the bond with a 3% interest rate will become more valuable than new bonds paying 2%. If the investor sells the bond before its maturity date, it is likely to be at a higher price than it was a year ago when new bonds were also paying 3%.
U.S. Government Bonds vs. Foreign Government Bonds
Just as you can buy shares in foreign companies, you can buy bonds issued by foreign governments (and foreign companies). This is one way to diversify your investment portfolio.
Like U.S. government bonds, international bonds pay interest semi-annually or annually. However, international bonds are considered riskier than U.S. government bonds, especially those issued by emerging market countries.
One reason is that buying foreign government bonds can expose investors to currency risks – the chance that the foreign currency will decline against the U.S. dollar. This can be mitigated by buying foreign debt denominated in U.S. dollars.
Additional risks include credit risk (U.S. government bonds are virtually free of default risk), liquidity risk, and interest rate risk.
Advantages and Disadvantages of Government Bonds
Advantages
- Low risk for U.S. bonds: Bonds issued by the U.S. government are considered almost free of default risk.
- Provide a stable income source: Bonds provide predictable and steady income through semi-annual or annual interest payments.
- Easy access: Bonds can be purchased directly from the U.S. Department of the Treasury or through a brokerage firm or bank. Many investors buy bonds through mutual funds or exchange-traded funds.
- Liquidity:
- Bonds do not have to be held until maturity and can be easily sold in the secondary market, although this does not always happen at a profit.
- Some bonds have tax advantages: Some U.S. Treasury bonds are exempt from state and federal taxes.
- Relatively low yield rates: The principle “low risk, low return” usually applies to bonds, especially when compared to stocks.
- Interest rate risk: If market interest rates rise, a bond that pays a lower interest rate will be worth less in the secondary market.
- Currency and country risk: Bonds issued by foreign countries may expose the investor to risks related to the political or economic stability of that country and fluctuations in currency exchange rates against the U.S. dollar.
- May not keep pace with inflation: Bond returns may lag behind the inflation rate.
- Taxation on foreign bonds: Income from foreign bonds is often subject to taxation.
Disadvantages
What This Means for Individual Investors
Government bonds can be effective in reducing investment portfolio risk. Investors who rely on income appreciate the expected cash flow from government bonds. However, it’s important to monitor market interest rates to determine whether your interest rate is keeping pace with inflation. If necessary, you may want to work with an investment advisor to evaluate your options if bonds are losing value.
Key Takeaways
Governments issue bonds to pay for services or other obligations. Government bonds provide expected and steady income and are considered low risk. Bonds can be purchased directly from the U.S. Department of the Treasury or through a brokerage firm or bank. Bonds can also be acquired through mutual funds or exchange-traded funds. Bonds come with maturities ranging from less than a year to 30 years. However, U.S. bonds are relatively liquid and can be sold in the secondary market before maturity.
Source: https://www.thebalancemoney.com/what-are-government-bonds-5198880
Leave a Reply