What are government bonds?
Learn about government bonds and debt securities issued by governments to raise capital. Find out how they work, the different types of bonds & the potential benefits of investing.
- Government bonds can be a low-risk investment option for retail investors who are looking for a stable source of income and to reduce their overall portfolio volatility. They are generally considered to be some of the safest investments available since they are backed by the full faith and credit of the government.
- Retail investors can buy government bonds through a broker. While the process of buying and selling government bonds can be more complicated than other investments, such as stocks or mutual funds, resources are available to help investors navigate the process.
- When investing in government bonds, retail investors should pay close attention to the bond's maturity date, coupon payments (if any) and yield. They should also be aware of the potential risks associated with investing in government bonds, such as inflation risk and interest rate risk, and consider how these risks may impact their investment over time. Overall, government bonds can be a valuable addition to a diversified investment portfolio, particularly for investors looking for a low-risk source of income.
What are government bonds?
Government bonds are debt securities issued by a government to finance its operations or to fund specific projects. When you buy a government bond, you are essentially loaning money to the government. The government agrees to pay you interest on that loan for a set period, and at the end of that period, they will repay the bond's principal amount.
Government bonds are considered to be among the safest investments available because they are backed by the full faith and credit of the government that issued them. This means that if the same government issues bonds, it is legally obligated to repay the bondholders. And in most cases, they have the ability to do so.
As a result, government bonds are often used as a benchmark for measuring the risk of other investments in government debt. The interest rate on government bonds is generally lower than the rate on other types of bonds, such as corporate bonds, but they are considered to be less risky because of the government backing.
How do government bonds work?
Government bonds work by allowing investors to lend money to the government for a specific period of time in exchange for regular coupon interest payments and the return of principal at maturity. When the government needs to raise money to fund its operations or projects, it issues bonds with a specific interest rate and maturity date.
Investors can purchase these bonds at the initial offering price, which is typically set at face value, and then hold them until maturity. At maturity, the investor receives the face value of the bond, plus any remaining coupon interest payments that have not yet been paid out.
The interest rate on government bonds is set based on market conditions and the creditworthiness of the government issuing the bonds. If the government is considered to be a low-risk borrower, it may be able to offer a lower interest rate, while a higher-risk borrower may need to offer a higher interest rate to attract investors.
Government bonds are typically sold through auctions, where potential investors bid on the bonds. The highest bidder receives the bond at the price they bid, and all successful bidders receive the same interest rate. This process helps ensure that the bonds are sold at a fair market price.
Types of government bonds
There are several types of government bonds, such as:
These are long-term bonds issued by governments, with maturities ranging from 10 to 30 years. They pay a fixed interest rate every six months and are considered one of the safest investments available.
These are medium-term bonds issued by governments, with maturities ranging from 2 to 10 years. They also pay a fixed interest rate every six months and are considered less risky than stocks or corporate bonds.
These are short-term bonds issued by governments, with maturities ranging from a few days to one year. They are sold at a discount to their face value and do not pay regular interest, but are instead redeemed for their full face value at maturity.
These are bonds issued by state and local governments to finance infrastructure projects. They are exempt from federal taxes and may also be exempt from state and local taxes in the state where they are issued.
These are bonds issued by government-sponsored entities, such as Fannie Mae and Freddie Mac, which are not directly backed by any government but are considered to be relatively safe.
These are bonds issued by foreign governments, which are often denominated in the country's own currency. They may be riskier depending on the creditworthiness of the issuing country.
How to buy and sell government bonds
Retail investors can buy and sell government bonds in Australia through several channels:
Through a broker: Retail investors can also buy and sell government bonds through a broker. Brokers can provide access to a wider range of government bonds and can facilitate the trading of bonds. Fees and commissions may apply when using a broker.
Via exchange-traded funds (ETFs): ETFs that invest in Australian government bonds are available on the Australian Securities Exchange (ASX). These ETFs allow investors to gain exposure to a diversified portfolio of government bonds with a lower minimum investment than buying individual bonds.
There are two types of exchange-traded Australian government bonds available on the Australian Securities Exchange (ASX): exchange-traded treasury bonds (eTBs) and exchange-traded treasury indexed bonds (eTIBs). These ETFs allow investors to gain exposure to a diversified portfolio of government bonds with a lower minimum investment than buying individual bonds. Some of the most traded ones on the ASX are the BetaShares Australian Government Bond ETF ($AGVT), the iShares Treasury ETF ($IGB) and the Vanguard Australian Government Bond Index ETF ($VGB).
How is interest paid on bonds?
Here are some examples of how interest can be paid on bonds:
Fixed when the bond is issued, doesn't change until the bond expires.
Are paid according to the fixed rate assigned to the bond when it was issued.
A more predictable, steady flow of income. Face value appreciates if interest rates fall below expectations.
Changes with market volatility, usually a market rate + a spread (cash returns +1%, for instance).
Might rise or fall according to inflation or change in the rate.
Offers the opportunity of bigger returns, though market volatility might be higher.
Changes along with the underlying index (like CPI +3%).
Coupons and face value rise or fall according to the underlying index.
Protection from inflation, allows you to forecast how much you are getting in real interest.
How to determine the value of a government bond?
The value of a government bond is determined by a variety of factors, including the current market interest rates, the bond's coupon rate, the bond's credit rating, and the remaining time until maturity.
There are a few key metrics used to evaluate the value of a government bond:
Yield to maturity: The yield to maturity is the rate of return earned by an investor who buys a bond at a certain price and holds it until maturity. The yield is calculated based on the bond's coupon rate, its current market price, and the remaining time until maturity. The yield can help investors compare the relative value of different bonds and make informed investment decisions.
Price: The price of a bond is the current market value of the bond, which can fluctuate based on a variety of factors. If interest rates rise, the price of a bond will typically fall, since new bonds issued at higher rates will be more attractive to investors. Conversely, if interest rates fall, the price of a bond will typically rise, since existing bonds with higher coupon rates become more valuable.
Credit rating: The credit rating of a bond issuer, which is assigned by rating agencies such as Standard & Poor's or Moody's, can also affect the value of a bond. A higher credit rating indicates that the issuer is more creditworthy and less likely to default on the bond, which can make the bond more valuable. Conversely, a lower credit rating indicates that the issuer is riskier and may be more likely to default, which can make the bond less valuable.
In general, the value of a government bond is determined by a combination of these factors, as well as other market conditions such as supply and demand. Investors can use these metrics to evaluate the relative value of different bonds and make informed investment decisions based on their investment goals and risk tolerance.
What moves the price of government bonds?
The prices of government bonds can be affected by a variety of factors, including changes in interest rates, economic conditions, inflation, and the creditworthiness of the bond issuer. Here are some of the most important factors that can move the prices of government bonds:
- Interest rates: Changes in interest rates can have a significant impact on the prices of government bonds. If interest rates rise, the prices of existing bonds with lower coupon rates will typically fall, since new bonds with higher rates become more attractive to investors. Conversely, if interest rates fall, the prices of existing bonds with higher coupon rates will typically rise, since they become more valuable.
- Economic conditions: Economic conditions such as growth rates, inflation, and unemployment can also affect the prices of government bonds. For example, if the economy is growing rapidly and inflation is high, investors may demand higher interest rates to compensate for the increased risk of inflation. This can cause the prices of existing bonds to fall.
- Creditworthiness: The creditworthiness of the bond issuer can also affect the prices of government bonds. If a bond issuer's credit rating is downgraded, investors may demand higher interest rates to compensate for the increased risk of default. This can cause the prices of existing bonds to fall.
- Supply and demand: The prices of government bonds are also affected by supply and demand. If there is high demand for bonds, their prices will generally rise. While if there is low demand for bonds, their prices will generally fall.
- Market sentiment: Finally, market sentiment can also play a role in the prices of government bonds. If investors are optimistic about the economy and the outlook for interest rates, they may be more willing to buy bonds at higher prices. While if they are pessimistic, they may be more likely to sell bonds at lower prices.
Overall, the prices of government bonds are affected by a complex interplay of economic, financial, credit risk and geopolitical factors.
Pros and cons of government bonds
Like any investment, government bonds have their own set of advantages and disadvantages. Here are some of the key pros and cons of investing in government bonds:
- Safety: Government bonds are generally considered to be a safe investment since they are backed by the full faith and creditworthiness of the government. This means that there is lower risk of default, making government bonds a popular choice for risk-averse investors.
- Steady income: Most government bonds pay a fixed rate of interest, which can provide investors with a predictable and steady stream of income. This can be particularly attractive for retirees, institutional investors that require steady cash flow and other investors who rely on income from their investments.
- Diversification: Investing in government bonds can provide diversification benefits for investors since they tend to be less correlated with other asset classes such as stocks and real estate. This can help to reduce overall portfolio risk.
- Low returns: While government bonds are generally considered to be a safe investment, they also tend to have relatively low returns compared to other investments such as stocks or corporate bonds. This means that investors may not earn as much income or capital appreciation as they could with other investments.
- Inflation risk: Government bonds are not immune to inflation risk since rising inflation can erode the real value of the bond's coupon interest payments and principal value. This can be a particular concern for investors who are relying on their bond investments to provide income.
- Interest rate risk: Government bonds are also sensitive to changes in interest rates, which can cause the price of the bond to fluctuate. This can be a concern for investors who need to sell their bonds before maturity, as the market value of the bond dropped due to the inverse relationship between bond prices and interest rates.
Government bonds FAQs
Are government bonds a good investment?
Whether government bonds are a good investment for you depends on your investment goals, risk tolerance, and other factors. Historically, bonds have performed quite well as an investment despite the fact that over the long run, stocks tend to provide a higher return. Though equities might be a better investment in absolute returns, they are low-risk investments and might not be better on a risk-adjusted basis, as bonds are generally perceived as safer.
Why do governments issue bonds?
Governments issue bonds as a way to raise money to finance their operations and investments. Here are some of the main reasons why governments issue bonds:
Fund government operations: Governments use the proceeds from bond sales to fund their day-to-day operations such as paying salaries, providing public services, and maintaining infrastructure.
Finance capital projects: Governments also use bond proceeds to finance capital projects, such as building new schools, hospitals, roads, and bridges. These projects typically require large amounts of upfront capital, which can be difficult to raise through taxes or other sources of revenue.
Manage debt: Governments may also issue bonds to manage their debt levels. By selling bonds, governments can reduce their reliance on short-term debt and spread out their debt payments over a longer period of time, which can help to stabilise their finances.
Stimulate the economy: During times of economic downturn, governments may issue bonds as a way to stimulate the economy. By investing in infrastructure projects and other capital investments, governments can create jobs and boost economic growth.
What is the relationship between the price of a bond and its yield?
The price of a bond and its yield have an inverse relationship. When the price of a bond goes up, its yield goes down, and vice versa. This relationship is important to understand because it helps investors determine the value of a bond and make investment decisions.
The reason for this inverse relationship is that a bond's yield represents the return an investor will receive on their investment. The yield is calculated as the annual coupon interest payment divided by the bond's price, expressed as a percentage. As the price of a bond goes up, the yield goes down, since the same coupon interest payment is being spread over a bigger initial investment. Conversely, when the price of a bond goes down, the yield goes up, since the same coupon interest payment is being spread over a smaller amount of money.
For example, let's say you own a bond that pays an annual interest payment of $50 and has a current market price of $1,000. The yield on the coupon payments of this bond would be 5% ($50 divided by $1,000).
Now, let's say that the market price of the bond increases to $1,100. The yield on the bond would now be 4.55% ($50 divided by $1,100), since the same coupon interest payment is being spread over a larger amount of money.
When interest rates rise - bond prices fall and yields rise.
When interest rates fall - bond prices rise and yields fall.
This is because investors demand a higher yield to compensate for the lower interest rates available on new bonds, and as a result, the price of existing bonds must fall to increase their yield to match the new market rate.
Why are interest rates on government bonds usually lower than other bonds?
Interest rates on government bonds are usually lower than those on other bonds for a couple of key reasons:
- Lower default risk: Government bonds are considered to be some of the safest investments available, since they are backed by the full faith and credit of the government. Therefore, the risk of default on a government bond is very low, which means that investors are willing to accept a lower interest rate in exchange for the safety of their investment.
- Greater liquidity: Government bonds are some of the most liquid securities on the market, meaning they are easily bought and sold. This makes them more attractive to investors in comparison to corporate bonds and investors will factor this in their pricing model.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.