What is a “Government Bond”?
Government bonds are debt securities issued by governments in order to raise funds for their fiscal needs – such as spending on infrastructure or social projects, or other obligations. They are generally considered lower risk than corporate bonds as they are backed by a sovereign government. Most government bonds are designed to offer regular interest payments called coupons. The yield achieved on government bonds is typically lower than that of corporate bonds, but it can provide more stability during times of market stress. Some of the most popular high quality sovereign bonds include the Treasuries issued in the US, UK Gilts and German Bunds.
Key Learning Points
- Government bonds are usually fixed income securities issued by a sovereign government
- They usually offer regular interest payment in the form of a coupon along with the initial investment (principal) at maturity
- Government bonds are typically lower risk investment and therefore investors could expect lower yields relative to corporate bonds
- They could provide downside protection and capital preservation features during times of market turbulence
Government Bonds Explained
Countries can use different terms to refer to their bonds – for example in the US, they can be referred to as T-Bills (which mature in a year or less), Treasure Notes (which mature in 1-10 years) and Treasury Bonds referred to bonds which mature in over 10 years. Bonds are also referred to as Gilts in the UK and Bunds in Germany.
An alternative to fixed-coupon bonds is inflation-linked bonds, where rather than paying a fixed payment they offer an interest payment which tracks the inflation rate. These are referred to as TIPS in the US (treasury inflation-protected securities).
The risk profile of a government bond largely depends on the country issuing it and whether it is considered a stable and secure economy. US bonds are considered to be one of the most secure offerings available, and certainly a low risk offering compared to an emerging market bond. The US 10-year bond is generally considered as the lowest risk an investment as you might get in the market, so is often used as a benchmark for the risk-free rate when comparing investments.
How do Government Bonds Work?
Government bonds are usually fixed time investments and have an expiry date which is called maturity. When the bond expires, the bondholder receives back his/her original investment called ‘principal’ in addition to the regular coupon payments. The maturity of different bond issues could vary, but most common are maturities between 5 and 30 years.
An investor decided to put £1,000 into the following bond in 2021:
UK Gilt 3% 2031
This means that the coupon rate is 3% and the maturity date is 2031.
Therefore, the bondholder would receive 3% per annum of the Gilt’s value, i.e. £30.
3% x £1000 = £30
Assuming that the investor holds the bond until maturity and interest payments are not reinvested, the return on the investment will be:
Initial investment = £1,000
Coupon payments = £30 x 10 years = £300
Total = £1,000 + £300 = £1,300
Factors that Influence Bond Prices
There are two major factors that influence the price of government bonds – interest rates and economic policies. Interest rates and government bond prices have an inverse relationship meaning that should interest rates increase, bond prices fall and vice versa.
Another factor that has an impact on bond prices is the rate of the coupon payments relative to interest rates and should the latter offer higher return, a new bond yielding higher will be issued. As a result, the initial bond would become less attractive because of the lower coupon and its value will decrease.
Credit ratings are designed to support investors by giving them guidance on the government’s ability to pay back the money received. Usually, a downgrade from one of the major credit rating agencies would have a negative impact on the bond’s value, where an upgrade is likely to improve the investor sentiment. Credit ratings are produced on the back of the government’s track record of repaying its financial obligations as well as forward-looking factors such as the country’s economic outlook and market and business climate.