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What are Government Bonds and Why would You Buy them?

What are Government Bonds and Why would You Buy them?

calendar 12/02/2024 - 06:15 UTC

Government bonds have a reputation for being less exciting than stocks, and the reason is not that government personnel are, somehow, less interesting people than the rest of us. Rather, the reason is that the financial returns that bonds offer are more modest than those stocks tend to produce. On the other hand, it’s also true that bonds possess the same advantage as many other unexciting things: safety. 

The reason they are safe is that the people who stand behind them are considered very trustworthy. In the case of the US Treasury Department, who issue US government bonds, their record of paying out is literally unblemished. But what, exactly, is the Fed paying you for when you redeem your government bonds? Well, they’re paying off the loan you gave them. When you buy a government bond, you are lending the government a certain amount of money, to be paid back on a fixed date, which is called the maturity date of your bond. In the meantime, you may receive interest payments for your bond, called coupons, which will make for some sort of steady income.

The fact that the government had to borrow money from you does not necessarily mean they’ve run upon hard times and deserve your pity. When you’re running the United States of America, there are plenty of things that need paying for on a constant basis: dams, bridges, war expenses, public parks, sidewalks. The government raises the money it needs through issuing bonds of various kinds to private citizens. When you buy them, the chief benefit you’re seeking out is safety but, just because a national government backs a bond, this doesn’t guarantee you’ll be paid back in full and on time. When the issuing government is not the United States, the risk of default may be real. This could have to do with the political situation in that country, or problems in its financial sector and central bank, for instance.

But what happens when a government fails to pay back the loan it took from you? Can you hire somebody to turn the screws on them until they pay up? And what are the different types of government bonds available out there?


Types of Government Bonds

Not all bonds are issued by the federal government. Local governments also need to raise money for their various projects, and they issue bonds of their own. These municipal bonds, known as munis, won’t pay you as much interest as, say, corporate bonds (which are issued by companies to raise money for their expansion), but your chances of getting back your principal are extremely high when you buy them. 

The term for US government bonds is Treasuries, which accounts for the letter T in the following list of bond types: T-Bills have short-term maturities of one year or less, so they’re appropriate for those who want to reclaim their money within a fairly close time horizon. If you’re willing to hand over your money for somewhere between two and ten years, the best option for you is a T-Note. And, finally, if it makes sense for you to lock your funds away for as much as ten to 30 years, you might want to go with the T-Bond.

If you choose a bond type with a longer maturity date, you’ll enjoy a higher interest rate or coupon rate for your bond. It follows that the coupon rate for a T-Bond is usually higher than for a T-Bill. And the reason is that, through handing over your funds for a longer period, you are accepting a higher degree of risk upon the value of your debt security. This risk could come from either jumps in inflation or interest rate adjustments by the Fed. In the case of inflation, imagine you owned a government bond that pays you interest of 4% a year: In the event that prices rise by 2% in that time, the real value of your bond’s interest rate would only be 2%. This explains the risk posed to your bond by inflation. As to the risk posed by interest rates, see the next section of this article.

When it comes to the question of how high a coupon rate you can expect to receive for your bond, the two key determining factors are the length of time until maturity is reached and the credit rating of the issuer. In the case of T-Bonds and T-Bills, the credit rating of the US government is pretty high, so don’t expect to be compensated for any additional risk on that score. But if your bond issuer has a less-than-sterling record of repaying their debt, you can demand a higher coupon rate as compensation for the added risk you’re accepting.


Treasuries and Interest Rates

An important sort of risk impacting the value of your Treasury is presented by interest rate fluctuations. Let’s say you buy a T-Bond with a face value of $1,000. This means that, when maturity is reached, you will be paid $1,000 by the federal government. In the intervening months, you will enjoy a coupon rate of 5%, which means you’ll receive $50 per year in interest payments, (usually paid in halves after six-month periods).

A complication arises when interest rates are hiked by the Federal Reserve in the interim. The effect of this could be to raise the coupon rate for bonds like yours up to 6%, increasing their appeal to buyers but reducing the appeal of your bond that offers a lower coupon rate. Consequently, the value of your T-Bond will drop. By contrast, in the event the Fed cut interest rates after you had bought your bond, the coupon rates for new bonds could drop to 4%, making your 5% bond comparatively attractive. Thus, it’s value would rise. When you’re examining the details of a bond and find mention of its “duration”, this refers to the degree to which the bond’s value will change when interest rates shift.


The Debt Ceiling

In most cases, there is no limit to how much debt a national government is allowed to issue, but one of the few exceptions is the United States. Since they passed the Second Liberty Bond Act in 1917, the US have had to worry about exceeding their debt limit. We saw a news item in 2023 that directly touched upon this issue, when the US Treasury came close to running into their debt ceiling. At the last minute (as is quite common in these instances), the US Congress agreed to suspend the debt limit until 2025.

These sorts of dramas happen because Congress tends to use the debt ceiling as a tool to force the government to do things, like cut down on spending. Until the White House agrees on certain reforms, Congress may refuse to adjust the debt ceiling, heightening the risk that the government will default on its debt. Back in 1995, when House Speaker Newt Gingrich dug his heels in on this score, then-President Bill Clinton also refused to budge from his spending plans and the result was a government shutdown.

The Debt Ceiling

What would be the results if the US government defaulted on its debt obligations? General confidence in the US as a faithful borrower would suffer a blow and this would, in turn, undermine financial markets around the globe. According to one estimate, a government default that lasted four months could cause the US dollar’s value to plummet, bring down stock prices by 33%, chop 4% of national GDP, and lead to the loss of 6 million jobs.


When Governments Default on their Debt

A famous example of this occurred in 1997 in Indonesia, Thailand, and Korea. These nations had been the rising stars of the east, drawing lots of international capital and experiencing swift economic growth. The problem arose, according to the IMF (International Monetary Fund), when foreign money providers began to “underestimate [these nations’] underlying economic weaknesses”, particularly the problems in their financial sectors. Confidence in these countries started to wane, which led to crashes in their stock markets and currency values. One crushing impact of the latter was in greatly inflating the cost of paying off foreign debt in local currency terms, which then became a real challenge for those governments.


Wrapping Up

In 2023, Fitch Ratings downgraded America’s credit rating from AAA to AA+, citing as a reason the accumulating national debt of the US government. In reality, however, most people continue to believe in the integrity of the US government as a borrower with equal conviction as beforehand. This means US Treasuries remain, perhaps, the single safest security on the market as far as public perception goes. For those with a conservative outlook on their finances, Treasuries will continue to remain a very appealing option into the foreseeable future.

The materials contained on this document should not in any way be construed, either explicitly or implicitly, directly or indirectly, as investment advice, recommendation or suggestion of an investment strategy with respect to a financial instrument, in any manner whatsoever. Any indication of past performance or simulated past performance included in this document is not a reliable indicator of future results. For the full disclaimer click here.

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