Trading and investing are hot topics. Cryptocurrency investing has made many wealthy. Retail traders and investors have jumped into the stock market using commission-free brokers. In early 2021, retail traders challenged Wall Street pros by piling into stocks such as GameStop, earning large returns for many.
In such an environment, it’s easy to think of a government bond as a thing of the past, but these loans are still useful!
Here’s everything you need to know about them if you’re looking for (relatively) safe haven investment.
What is a Government Bond
In its simplest sense, a government bond is a loan that investors provide to a government.
Governments raise money by issuing bonds for spending and obligations such as social security or for projects such as bridges or roads. When income from taxes does not cover government spending, then governments issue bonds to cover the difference.
More specifically though, bonds are investment securities. Unlike traditional bank loans, where one lending bank provides a large sum of capital to a lender, bonds are issued as investment securities similar to stocks.
These debt securities are known as fixed-income securities because they provide a fixed rate of return to investors.
For example, an investor might buy a five-year government bond worth $1,000. In return, the government will pay back a set level of interest at regular periods, say 5% each year, known as the coupon.
Then, after five years, the maturity date, the government will pay the investor the coupon of 5% but will also pay back the full value of the bond, or $1,000.
Types of Government Bonds
In the U.S., a government bond generally refers to a bond issued by the U.S. Treasury. As a result, these bonds are called Treasuries. Treasuries are commonly what we mean when we refer to government bonds.
Treasuries can have various coupons, depending on the prevailing interest rate at the time of issue, and various maturities.
- Treasury bills (T-bills) have a maturity of less than one year
- Treasury notes (T-notes) have a maturity of one to ten years
- Treasury bonds have a maturity of more than ten years, often as long as 30
Additionally, one popular Treasury bond does not pay a fixed coupon. Instead, its interest payments move in line with inflation rates. These bonds are known as treasury inflation-protected securities (TIPS).
States and cities within the U.S. can also issue bonds. These are known as Municipality bonds.
U.S. government agencies can also issue bonds known as Agency bonds. A government-affiliated agency would include Fannie Mae or Freddie Mac.
Non-U.S. Government Bonds
It is important to note that investors can buy bonds from governments around the world, not only from the U.S. government
When buying foreign bonds, such as bonds offered by the United Kingdom, the fundamental concepts are the same. These bonds have coupons and maturities just as Treasuries do.
However, foreign bonds have different names. In the U.K., government bonds are known as gilts. In Germany, government bonds are known as bunds. In Japan, government bonds are called JGBs.
How to Invest in Government Bonds
When a government issues bonds, it will usually do so through a bond auction. These auctions occur on a regular basis.
At the auction, which occurs virtually via a specialized electronic platform, the bond will be bought by large banks or financial institutions. Individual investors rarely buy government bonds directly from the government.
The institutions that specialize in attending government bond auctions then sell the bonds on, often to pension funds, other banks, and individual investors.
Generally speaking, individual investors can buy government bonds from any bank or broker that offers securities such as stocks.
Government Bond ETFs
In recent years, exchange-traded funds (ETFs) have become very common tools for individuals and others to invest in more complicated or less liquid products.
Bond ETFs, as their name suggests, trade on stock exchanges. This makes them simple to buy or sell. The benefit of a treasury bond ETF is that the ETF will manage buying new bonds as old bonds expire.
For example, as an investor, you might buy a treasury ETF that holds treasuries of various maturities between 1 and 5 years. The coupon payments of this ETF will depend on what precise bonds the ETF holds.
The managers of the ETF will handle buying and selling individual bonds so that you, the investor, do not need to worry about buying individual government bonds as they reach maturity and expire.
Generally, bond ETFs also pay coupon payments monthly rather than twice a year.
Government Bond Risks
It is important to note that government bonds, like any financial security, has a price that fluctuates every day.
You can hold a government bond as a long term investment and collect the coupon rate of return.
But you can also speculate on the price of the bond rising or falling.
Imagine that you bought $5,000 of 10-year T-Notes three years ago, which has a coupon of 4%. You bought the bonds at par, or at the face value of $5,000.
Today, you believe you can earn better returns on a particular stock that you have been following.
You can, very easily, sell your investment in 10-year T-Notes to another investor. However, the price at which you sell your T-Notes will not likely be the same as what you paid.
Today, investors might be willing to pay 98 cents on the dollar for 10-year T-notes that expire in seven years. A bond selling below its face value, or par, is said to be trading at a discount.
An investor buying your bonds would still get the same coupon rate, 4% on the $5,000, but will earn additional interest because they are paying only $4,900 for the bond portfolio.
Similarly, bond prices can rise – maybe in six months, the same $5,000 T-Note position is selling in the open market for 101 cents on the dollar. A bond selling above its face value is said to be trading at a premium.
Build an All-Weather Investment Portfolio Today
Bonds can be an important piece of an investment portfolio’s asset allocation for several reasons.
First, the steady coupon payments provide passive income.
Second, bond prices tend to be uncorrelated to the stock market. When stocks are rising, bond prices tend to be steady or slightly lower.
Third, when panic sets into a stock market or there is a recession, investors flock to the safety of government bonds, pushing government bond prices higher. In this way, government bonds help to offset the volatility of equity prices.