Government Bond. Market Cheese

Government Bond — this is a state issue-grade security aimed to attract free funds from individuals, and legal entities in the form of state loans for social needs. The government bond has an obligation of the state and its financial authorities to pay the owner a nominal value at the end of the established period and periodically pay a certain percentage during the period of validity.

What is Government Bond

A government bond is an IOU document, and the state acts as a debtor in this case. When individuals purchase government bonds, they lend money to the state to receive the income in the future. The time and terms of payment are known during the purchase. The key difference between bond and security is the ability to know the benefit in advance.

Government bonds are redeemed at the due date. At this time the issuer pays the face value to the bond’s owner. There are also perpetual bonds. If the government issues this bond, they are obligated to regularly pay income on it, but they may never repay it. At the same time, they usually have the right to redeem them at face value on certain dates, for example, once every five or ten years.

The annual payments on the bonds are named coupons. A coupon can be fixed or variable. If the income is fixed, the interest rate is set in advance and remains unchanged until the payment. The variable income is tied to some base value that can change. It can be the refinancing rate plus a certain fixed percentage.

The coupon yield is set when the bond is issued. There are two types of coupon yield — current yield and yield to maturity. The current yield measures the return on the bond to the holder after the bond has been purchased. The current yield doesn’t take into account any gains or losses that may be made or incurred when the bond is sold or redeemed. The yield to maturity means all sources of revenue: coupon income, income, or losses during manipulations with the bond.

The value of the coupon yield depends on several factors: the reliability of the issuer and the term of the bond issue. There are risks associated with the maturity of a bond, and the longer the maturity, the higher the rate of return should be. With a fixed rate, the coupon yield is initially known and doesn’t change throughout the entire circulation period.

The main reason to invest in government bonds is the stable payments and low risk of default. Also, the government bonds are tax-free and easy to resell. However, this investing instrument has some disadvantages. The first disadvantage is small payments. Government bonds are often affected by inflation, and they are risky if interest rates are high.

Basic types of government bonds:

Saving bonds. These are bonds issued by a government or local authorities. These securities can be sold or bought only by the government.
T-notes (Treasury notes). It is money issued by the Treasury to finance government spending. They mature within ten years. Until then, the government pays a fixed amount of funds.
T-bonds (Treasury bonds). These bonds are placed voluntarily among the population. Such a bond certifies the contribution by the holder of funds to the state budget, due to which the owner of the bonds acquires the right to receive a fixed income during the entire period of ownership.
TIPS (Treasury inflation-protected securities). They are indexed considering inflation. They are aimed to protect investors’ capital from depreciation. Their face value and coupon payments increase in value in line with rising consumer prices and retain their real value.

Risks of Government Bonds

Government bonds are considered quite a safe instrument for investment, but they have their risks too. Investors should pay attention to these risks to keep their money safe.

The first one is the risk of inflation. If the state economy has hard times, the securities lose value and become unprofitable. That’s why it is necessary to acquire the bonds of the state with a stable economy.

The second risk is related to liquidity. This means you can have no possibility to sell the bonds at a fair price if you plan to do it before the amortization. You can find no person who would buy your bonds.

And the third risk is related to the interest rate. There is a danger that average market rates on similar bonds will become higher. If your bonds have a fixed interest rate, and it turns out to be lower than the market rate, then your income could be higher if you invested in other securities.

To avoid these risks, check your investment and regularly follow the economic news of the state whose bonds you obtain. If you see that the economic situation is unpredictable and unstable, it is better to sell them. Read the rules of the issue carefully. Find out how often the money will be paid out and through which organizations. Know where all important information about securities will be published. Specify whether the issuer has the right to early redeem bonds and whether the holders of the bonds themselves can demand to do this.