Government Bonds

What is a “Government Bond”?

A government bond is a debt security issued by a government to support its public spending and obligations. It is considered a low-risk investment since it is backed by the government’s credit. There is always the possibility that a government may default on a bond, but typically the more stable a country, the less likely this is to happen. All governments receive a credit rating from the major credit rating agencies which helps guide investors who are looking to invest in bonds.

Investors see government bonds as a low-risk investment which is useful in diversifying an investment portfolio or providing a steady income stream. However, they usually offer lower returns compared to other investment classes. Emerging market countries, or those with a lower credit rating than stable economies, such as the US, will tend to offer higher interest rates (and therefore returns) on government bonds to offset the additional perceived risk in that market.

How Government Bonds Work

Government bonds are essentially loans made by investors to the respective government issuing the bonds. In return, they receive periodic interest payments, known as coupon payments, and will be repaid the face value of the bond at maturity. These bonds can have various maturities, ranging from short-term (less than one year) to long-term (up to 30 years or more).

A typical US Treasury bond could be worth US$1,000 and mature in 10 years paying 2% interest every six months to the investor. This means they would receive US$20 every six months and at the end of the 10-year tenure the US$1,000 would be returned to the investor.

Download a free Financial Edge template detailing how to calculate a bond’s interest and total return.

Types of Government Bonds

The US government offers several types of bond products, each with unique features and maturities:

US T-Bills: US T-Bills are short-term securities with maturities of one year or less. They are sold at a discount and do not pay interest before maturity. For example, a US$100 T-Bill could be purchased for US$98.80 and redeemed at $100 in six months’ time.

US T-Notes and T-Bonds: T-Notes have maturities ranging from two to ten years, while T-Bonds have maturities of more than ten years. Both pay interest every six months.

On-the-Run vs. Off-the-Run Bonds: On-the-run bonds are the most current issues of a particular maturity being sold by the US Treasury and are considered benchmarks for their maturity bracket. Off-the-run bonds are older issues that have lost this status to newer issuances.

STRIPS: STRIPS are treasury securities that have been separated into their individual interest and principal components, which are then sold separately as zero-coupon bonds.

TIPS (Treasury Inflation-Protected Securities): TIPS bonds are designed to protect investors from inflation. The principal value of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). Interest is paid semi-annually and is applied to the adjusted principal.

What are the Bond Terms

Bond terms include the maturity date, the size of the issuance, and the yield. The issuer determines these terms and announces the pending issuance to collect bids from investors. The maturity and size will be driven by the government’s spending plans and its need to service its national debt. Short-term spending will typically be funded by short-term bonds such as T-bills. The yield will be determined by economic factors such as inflation and other market conditions.

How To Buy Bonds

Investors can buy government bonds through auctions where they can place competitive or non-competitive bids. Non-competitive bids are allocated first, and the auction’s high yield is determined based on competitive bids. Once issued, bonds trade on the secondary market where prices can fluctuate driven predominately by interest rates. Investors can buy bonds directly or through a broker who can help determine the investment goals required.

Factors That Can Affect the Price of Bonds

Several factors can influence the price of government bonds, including:

• Interest Rates: when interest rates rise, bond prices typically fall, and vice versa.
• Inflation: higher inflation can erode the purchasing power of the bond’s future payments, leading to lower bond prices.
• Credit Quality: the perceived creditworthiness of the issuing government can affect bond prices – higher credit risk can lead to lower prices.
• Supply and Demand: the overall demand for bonds and the supply of new bonds can impact prices.

Foreign Government Bonds

Foreign government bonds are issued by governments outside the investor’s home country. Examples in the US include Japanese Government Bonds (JGBs), UK Gilts, and German Bunds. This is typically done by governments to attract foreign investors. It will also diversity the country’s debt portfolio and extend it to include bonds issued in foreign currencies. From an investors’ perspective, foreign government bonds offer diversity for their portfolios and give access to potentially higher interest rates as well as FX exposure.

Pros and Cons of Government Bonds

Advantage of a Government Bond

The main advantage of government bonds is that they are considered low risk investments. They are virtually credit risk-free, making them a safe investment option for many. Additionally, government bonds provide a stable income stream through regular interest payments and are often used as benchmarks for other bond investments within a country.

Disadvantages of Government Bond

The main disadvantage of government bonds is that it will likely offer lower returns compared to other investments.

Government Bond Risks

While government bonds are generally considered low risk, they are not entirely risk-free. Some risks include:

• Interest Rate Risk: the risk that changes in interest rates will affect bond prices.
• Inflation Risk: the risk that inflation will erode the purchasing power of the bond’s payments.
• Credit Risk: although rare, there is a risk that the government could default on its debt obligations.
• Liquidity Risk: the risk that the bond may not be easily sold at a fair price.

How Do Investors Buy Government Bonds?

Investors can buy government bonds through primary markets (auctions) or secondary markets (trading existing bonds). The process involves placing bids and potentially participating in the when-issued market.

The government bond issuance process involves several key steps:

• Determining Maturity and Size: The issuer (government) determines the maturity date and the size of the bond issuance.
• Announcement and Bidding: The issuer announces the bond issuance and collects bids from investors. Investors can place bids at any yield, but they might miss out on allocation if their bid is too low.
• Non-Competitive and Competitive Bids: Non-competitive bids are allocated first. The auction’s high yield is then determined based on the competitive bids, but this yield applies to both competitive and non-competitive bidders. After filling all non-competitive bids, the remaining securities are allocated to competitive bidders.

Once issued the bonds will then trade on the secondary market.

US Treasury Auction Result

Here is an example of a US Treasury Auction result. These are released by the US Department of the Treasury once an auction is complete. The results will show the bid-to-cover ratio as well as the types of bidders in the auction.

What is an Example of Non-U.S. Government Bonds?

Examples of non-U.S. government bonds include:

Japan (JGBs)

Japanese government bonds (JGBs) are issued by Japan’s Ministry of Finance and are widely held domestically in Japan. They include:

• • Treasury Discount Bills: short-term discount securities, typically with maturities of one year or less.
  • Fixed Coupon JGBs: bonds that pay a fixed coupon, with maturities ranging from short to long term.
  • Inflation-linked JGBs (JGBi): inflation-linked bonds whose principal is adjusted according to changes in Japan’s Consumer Price Index (CPI).
    • Japan’s CPI has historically reflected low inflation rates, and the inflation-linked bonds are used primarily for long-term protection against unexpected inflationary pressures.

UK (Gilts)

In the UK, government bonds are commonly known as Gilts. The term “Gilt” originates from the gilt-edged paper these bonds were originally printed on, symbolizing their high credit quality and reliability. Gilts are issued in three main types:

• • • Treasury Bills: short-term discount instruments, typically with maturities of one year or less.
    • Conventional Gilts: fixed-coupon bonds with maturities ranging from short to long term.
    • Index-linked Gilts: inflation-linked bonds whose principal is adjusted in line with changes in the Retail Price Index (RPI), which is different from CPI as it includes housing costs.

Germany (Bunds)

German government bonds, known as Bunds, are issued by the federal government of Germany. Bunds are considered the safest Euro-denominated bonds, often used as a benchmark for the Eurozone. They are known for low (or even negative yields during the 2010s), reflecting their demand as a secure investment option within Europe.

• • • Bubills: these are short-term discount bonds, typically with maturities of six months to one year, similar to T-Bills in the US or UK.
    • Bunds: conventional fixed-coupon bonds with maturities up to 30 years, used as the Eurozone’s primary benchmark for long-term interest rates.
    • Inflation-linked Bunds: bonds that adjust their principal based on the Harmonized Index of Consumer Prices (HICP), which is a standardized inflation measure across the Eurozone.

What is the Main Difference Between a Corporate Bond and a Government Bond?

The primary difference between corporate bonds and government bonds lies in the issuer. Government bonds are issued by governments, while corporate bonds are issued by corporations. Government bonds are generally considered safer due to the government’s ability to tax and generate revenue to repay the bonds. Corporate bonds carry higher risk but often offer higher yields to compensate for that risk.

The “Sovereign Ceiling”

Government bonds will in almost all cases have a higher credit rating than a corporate based in that jurisdiction. This is known as the sovereign ceiling.

Developed market economies will be considered the lowest risk investments and therefore have the highest credit rating (or ceiling). The US government has never defaulted on a bond to date, so its bonds are considered a proxy for the global risk-free rate.

Emerging markets countries will expect to have lower credit ratings than more developed countries, and their bond credit rating will be driven by the economic, geographical and political considerations within that market. As a rule, corporate credit ratings will not be higher than the country credit rating where they are based. In an unusual situation, a corporate domiciled in a turbulent emerging market but with sales driven from international, more stable economies, may in some circumstances warrant a similar or better credit rating than the sovereign debt. There may be instances where a company has more stable finances than a country.

Do Corporate Bonds Outperform Government Bonds?

Corporate bonds can outperform government bonds as they offer a higher yield because they carry higher perceived risk. Investors demand better returns for taking on the additional risk associated with corporate bonds. However, the performance of corporate bonds relative to government bonds can vary based on economic conditions and the financial health of the issuing corporations.

How to Trade Government Bond Futures

Trading government bond futures involves buying or selling contracts that represent the future delivery of government bonds. These futures are traded on exchanges and can be used for hedging or speculative purposes. The price of bond futures is influenced by factors such as interest rates, inflation expectations, and overall market sentiment.

Conclusion

Government bonds are low-risk investments issued to cover the cost of public spending and servicing national debt. Investors buy them as part of portfolio diversification, and to gain access to regular interest repayment income streams (unless short term) and the safe return of capital at maturity. Government bonds provide a benchmark for other interest rates and are considered safe due to a government’s ability to issue more bonds or create money to repay the outstanding bondholders if necessary. Due to the low-risk nature, they tend to offer lower returns compared to other investment options.

Additional Resources

Bonds

Corporate Bonds

Government Bonds