A government bond is a debt security issued by a government to support government spending and obligations. Government bonds can pay periodic interest payments called coupon payments. Government bonds issued by national governments are often considered low-risk investments since the issuing government backs them.
Government bonds issued by a federal government may also be known as sovereign debt. The UK government and other government in Europe, developed countries as well as emerging markets also issues bonds with varying yield and maturity.
Government bonds are issued by governments to raise money to finance projects or day-to-day operations. The U.S. Treasury Department sells the issued bonds during auctions at regular intervals throughout the year. Only certain registered participants, often large banks, can buy U.S. government bonds directly at auction. When the government holds a bond auction, each buyer submits its purchase bid, and the auction continues until all the bonds are duly distributed.
Some Treasury bonds trade in the secondary market. Individual investors, working with a financial institution or broker, can buy and sell previously issued bonds through this marketplace. Treasuries are widely available for purchase through the U.S. Treasury, brokers, and exchange-traded funds (ETFs), which contain a basket of securities.
Fixed-rate government bonds can have interest rate risk, which occurs when interest rates are rising and investors are holding lower paying fixed-rate bonds as compared to the market. Also, only select bonds keep up with inflation, which is a measure of price increases throughout the economy. If a fixed-rate government bond pays 2% per year, for example, and prices in the economy rise by 1.5%, the investor is earning only 0.5% in real terms.
Government bonds from the U.S. Treasury are some of the most secure worldwide, while those floated by other countries may carry a greater degree of risk.
Due to this nearly risk-free nature, market participants and analysts use Treasuries as a benchmark in comparing the risk associated with securities. The 10-year Treasury bond is also used as a benchmark and guide for interest rates on lending products. Due to their low risk, U.S. Treasuries tend to offer lower rates of return relative to equities and corporate bonds.
However, government-backed bonds, particularly those in emerging markets, can carry risks that include country risk, political risk, and central-bank risk, including whether the banking system is solvent.
The Uses of Government Bonds
Government bonds assist in funding deficits in the budget of the issuing country and are used to raise capital for various projects such as infrastructure spending. However, government bonds can also used by Central Banks to control a nation’s money supply.
When a central bank repurchases its government’s bonds, the money supply increases throughout the economy as sellers receive funds to spend or invest in the market. Any funds deposited into banks are, in turn, used by those financial institutions to loan to companies and individuals, further boosting economic activity.
U.S Government Treasuries
The U.S. government has never defaulted on a loan, and it would take a mighty big catastrophe before the U.S. Treasury could collapse. As an investor you will not have to worry about the U.S. not paying you back if you buy some of its bonds.
An advantage of Treasuries is that interest payments are exempt from local and state taxes (however, not from Federal income taxes).
Treasury Bonds, Bills and Notes
The United States government issues several different kinds of bonds through the Bureau of the Public Debt, an agency U.S. Department of the Treasury. Treasury debt securities are classified according to their maturities:
- Treasury Bills have maturities of one year or less.
- Treasury Notes have maturities of two to ten years.
- Treasury Bonds have maturities greater than ten years.
Treasury Bills are issued in three maturities. Bills with 91-day and 182-day maturities are auctioned by the Treasury each Monday. 364-day Bills are auctioned every four weeks on Thursday, 13 times a year. The interest rate of T-Bills is determined at each auction, depending on what bidders are willing to pay. T-Bills do not make interest payments, however. Instead, they are purchased at a discount to face value. They are the only Treasury securities that sell at a discount.
U.S. Treasury Notes are issued in two, three, five, and ten-year maturities. The two year and five year Notes are auctioned each month, while the three year Notes are issued quarterly, and ten year Notes are auctioned six times a year. All Notes pay interest twice a year, and expire at par value.
Treasury Bonds are usually issued in thirty-year maturities, and pay interest twice a year.
European Government Bonds
Although individual countries in Europe still have national bond markets where governments, sub sovereign entities and corporations in residence issue bonds, and individual investors participate, the European market, especially across the Euro-zone countries, is increasingly acting like one market.
- The primary advantage of considering investing in government bonds is comparative safety of the investment, in particular, the promise that interest and principal will be paid on time.
- Payments of straight government bonds are predictable; many people invest in them to preserve and increase their capital and to receive a dependable income stream—to help meet living expenses during retirement, for example, or to fund specific objectives.
- Government bonds are available with a wide range of maturity dates. This allows an investor to structure a portfolio to achieve financial goals at specific time horizons.
- Investors are effectively guaranteed to receive interest and principal as promised; the underlying value of the bond itself may change depending on the direction of interest rates. As with all fixed-income securities, if interest rates in general rise after a government bond security is issued, the value of the issued security will fall, since bonds paying higher rates will come into the market.
- If interest rates fall, the value of the older, higher-paying bond will rise in comparison with new issues. The interest payable (called the coupon) will remain the same for the investor assuming it is a fixed rate bond; only its value will change if you sell it before maturity.
- The bond market is liquid and accessible to both institutional investors and individual investors, it’s a market where there are ready buyers and sellers willing to trade at competitive prices for both institutional investors such as pension funds and insurance companies but also individual investors.
Emerging Markets Bond
Economic growth in emerging markets has been strong and there is scope for more growth as demand increases with an increasing middle class population. Emerging markets also rely less on demand from developed markets and can withstand the current slowdown in growth being experienced in the core markets. Governments in emerging markets are in a strong financial position than before reducing the risk of default in the debt repayments.
Emerging markets also have increasing trade ties amongst themselves thereby boosting exports which are supported by increasing domestic demand.
Population growth in most emerging markets is still on the rise and there is also an increase in the middle class & economically active population. An increasing population and a growing disposable income among most families, means the long-term economic growth outlook is promising.
Debt levels in most emerging economies are much lower than in developed countries. The euro zone has debt problems which have forced member countries to take drastic austerity measures which have in turn hindered economic growth. The US which is the world’s largest economy has ever increasing levels of debt compared to its GDP which have slowed its economy. This has prompted the countries Federal Reserve to resort to Quantitative Easing in an effort to stimulate to economic activity.
Yields for emerging market debt are still much higher than in developed markets. However the improved fiscal policy, governance and reduced risk of default mean there is potential that the yields will get lower. It is therefore important to note that continued improvements in ratings on an emerging markets debt will drive the yield lower but it is still greater than that of developed markets.
The growth in emerging economies also helps their currencies gain value against those of developed markets which may be debased as part of fiscal policy to boost exports or held back by Central Banks. This will provide additional returns for investors whose initial investment will have been in the lower value emerging market currency.
Emerging markets offer portfolio diversification to asset portfolios which may already include equities and debt from developed market as well as equities from emerging markets.
Risks Associated with Emerging Market Debt:
- Market Risk: the confidence level of the market in which the assets (bonds) are traded will play a huge part in determine the value of the assets. If there is positive sentiment amongst investors for this asset class, the value may increase and vice versa.
- Liquidity Risk: if a portfolio’s assets need to be redeemed for whatever reason there must be willing buyers in market to sell the bonds to as required. Debt assets carry the risk that there may not be enough liquidity or market participants to purchase the asset that a portfolio wants to sell when required to do so.
- Exchange rate risk: changes in exchange rates may reduce or increase the returns an investor might expect to receive independent of the performance of such assets. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging), may not be effective. Hedging also involves additional risks associated with derivatives.
- Custodian risk: insolvency, breaches of duty of care or misconduct of a custodian or sub-custodian responsible for the safekeeping of the Portfolio’s assets can result in loss to the Portfolio.
- Interest rate risk: when interest rates rise, bond prices fall, reflecting the ability of investors to obtain a more attractive rate of interest on their money elsewhere. Bond prices are therefore subject to movements in interest rates which may move for a number of reasons, political as well as economic.
- Credit risk: the failure of a counterparty or an issuer of a financial asset held within the Portfolio to meet its payment obligations will have a negative impact on the Portfolio.
- Derivatives risk: certain derivatives may result in losses greater than the amount originally invested.
- Counterparty risk: a party that the Portfolio transacts with may fail to meet its obligations which could cause losses.
- Emerging markets risk: emerging markets are likely to bear higher risk due to lower liquidity and possible lack of adequate financial, legal, social, political and economic structures protection and stability as well as uncertain tax positions.