What are government bonds?
Learn all about government bonds: including what they are, how they work, and why they move in price.
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A government bond is a type of debt-based investment, where you loan money to a government in return for an agreed rate of interest. Governments use them to raise funds that can be spent on new projects or infrastructure, and investors can use them to get a set return paid at regular intervals.
How do government bonds work?
When you buy a government bond, you lend the government an agreed amount of money for an agreed period of time. In return, the government will pay you back a set level of interest at regular periods, known as the coupon. This makes bonds a fixed-income asset.
Once the bond expires, you’ll get back to your original investment. The day on which you get your original investment back is called the maturity date. Different bonds will come with different maturity dates – you could buy a bond that matures in less than a year, or one that matures in 30 years or more.
Government bond example
Say, for instance, that you invested A$10,000 into a 10-year government bond with a 5% annual coupon. Each year, the government would pay you 5% of your A$10,000 as interest, and at the maturity date they would give you back your original A$10,000.
Types of government bond
The terminology surrounding bonds can make things appear much more complicated that they actually are. That’s because each country that issues bonds uses different terms for them.
UK government bonds, for example, are referred to as gilts. The maturity of each gilt is listed in the name, so a UK government bond that matures in two years is called a two-year gilt.
In the US, meanwhile, bonds are referred to as treasuries. Treasuries come in three broad categories, according to their maturity:
- Treasury bills (T-bills) expire in less than one year
- Treasury notes (T-notes) expire in one to ten years
- Treasury bonds expire in expire in more than ten years
Other countries will use different names for their bonds – so if you want to trade bonds from governments outside of the US or UK, it’s a good idea to research each market individually.
You can also buy government bonds that don’t have fixed coupons – instead, the interest payments will move in line with inflation rates. In the UK these are called index-linked gilts, and the coupon moves with the UK retail prices index (RPI). In the US, they are called treasury inflation-protected securities (TIPS).
Buying and selling government bonds
Just like shares, government bonds can be held as an investment or sold on to other traders on the open market.
Using our above example, say that your 10-year bond is half way to maturity, and that you’ve spotted a better investment elsewhere. You want to sell your bond to another investor, but because better investment opportunities have arisen your 5% coupon now looks a lot less attractive. To make up the shortfall, you might sell your bond for less than the A$10,000 you originally invested.
An investor buying the bond would still get the same coupon rate – 5% on A$10,000. But their yield would be higher, because they paid less to get the same return.
A bond with a price that is equal to its face value is said to be trading at par – if its price drops below par it is said to be trading at a discount, and if its price rises above par it is trading at a premium.
Which factors affect the prices of government bonds?
Supply and demand
Just like any financial asset, government bond prices are dictated by supply and demand. The supply of government bonds is set by each government, who’ll issue new bonds as and when they are needed. Demand for bonds is dependent on whether the bond looks like an attractive investment.
Interest rates can have a major impact on the demand for bonds. If interest rates are lower than the coupon rate on a bond, demand for that bond will rise as it represents a better investment. But if interest rates rise above the coupon rate of the bond, demand will drop.
How close the bond is to maturity
Newly-issued government bonds will always be priced with current interest rates in mind, meaning that they’ll usually trade at or near their par value. And by the time a bond has reached maturity, it’s just a pay out of the original loan – meaning that a bond will move back towards its par value as it nears this point.
The number of interest rate payments remaining before a bond matures will also have an impact on its price.
Government bonds are usually viewed as low-risk investments, because the likelihood of a government defaulting on its loan payment tends to be low. But defaults can still happen, and a riskier bond will usually trade at a lower price than a bond with lower risk and a similar interest rate.
The main way of assessing the risk of a government defaulting is through its rating from the three main credit rating agencies – Standard and Poor’s, Moody’s and Fitch.
Government bond risks
You might hear investors say that a government bond is a risk-free investment. Since a government can always print more money to meet its debts, the theory goes, you’ll always get your money back when the bond matures.
In reality, the picture is more complicated. Firstly, as we’ve seen with Greece’s debt crisis, governments aren’t always able to produce more capital. And even when they can, it doesn’t prevent them from defaulting on loan payments.
But aside from credit risk, there are a few other potential pitfalls to watch out for with government bonds: including risk from interest rates, inflation and currencies.
What is interest rate risk?
Interest rate risk is the potential that rising interest rates will cause the value of your bond to fall. This is because of the effect that high rates have on the opportunity cost of holding a bond when you could get a better return elsewhere.
What is inflation risk?
Inflation risk is the potential that rising inflation will cause the value of your bond to fall. If the rate of inflation rises over the coupon rate of your bond, then your investment will lose you money in real terms. Index-linked bonds can help mitigate this risk.
What is currency risk?
Currency risk only applies if you buy a government bond that pays out in a different currency to your reference currency. If you do this, then fluctuating exchange rates may see the value of your investment drop.
How to get started with government bonds
When a government wants to issue bonds, it will usually do so via a bond auction, where the bond will be bought by large banks or financial institutions. Those institutions will then sell the bonds on, often to pension funds, other banks, and individual investors. Sometimes, governments sell bonds directly to individual investors.
Alternatively, IG offers one other way of speculating on government bonds. CFD trading enables you to trade on fluctuating bond prices using leverage, without having to buy or sell the bonds themselves. Find out more about how to trade bonds.
Government bond ETFs are funds that can track the prices of fixed-income securities. They offer many of the benefits of buying government bonds, but with additional liquidity and transparency.Learn all about government bonds including what they are, the different types of bonds, how they work and which factors affect their price.
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