To understand government bonds, let’s first look at what a bond is?
A bond is a form of borrowing by companies or governments from investors willing to purchase these bonds for a fixed period of time. In return the company or government pays regular interest to the investors over the life time of the bond. The interest rate applicable is dependent on the credit rating of the issuing party.
Definition of Government Bonds
A government bond is issued by a country’s government with a promise of periodic coupons or interest payments as well as settlement of the face value of the instrument at maturity.
Characteristic of Government Bonds
- Denominated in the currency of the country that issues the bond
- Has a fixed period with interim coupon or interest payments
- Also called Sovereign Bonds
- Considered low risk since they are issued by governments
- The interest rates applicable of such bonds are generally low and linked to the credit worthiness of the country of issue.
- Can be traded in the open market and does not need to be held until maturity. Usually traded at a discount in the open market (price lower than the face value of the bond).
- Bonds are usually issued via regular auctions by the Central Bank or Treasury of the country
Why do Governments Issue Bonds
Governments issue bonds to borrow from the market to fund deficits in budgets or fund large infrastructure projects. Bonds are also used by governments to control the money supply in the economy. When Bonds are issued the money supply in the economy is reduced while when they are purchased back by the governments the supply of money increased.
Types of Government Bonds
- Treasury Bonds
- Savings Bonds
What are Treasury Bonds?
These are debt instruments that can be issued for periods 10 to 30 years by the respective government’s Central Bank or Treasury. They are long term debt instruments with periodic coupon payments usually semi-annual and issued in multiples of 1,000’s. They are transferable securities.
Simple Example of a Treasury Bond
Face Value: 100,000
Coupon Rate (Interest Rate) 5% p.a.
Coupon payment Semi-annual (twice a year)
Coupon amount 100,000 * 5% / 2 = 2,500
At maturity the face value of the bond will be paid to the investor.
What are Savings Bonds?
Savings Bonds are non-transferable and non-negotiable government instrument issued to retail investors. They are usually issued in multiples 50/100/500 and a maximum holding value per investor. These bonds are usually except from Income Tax. The period of issue can be from 10 to 30 years. Interest rates can be locked for the period of issue or for example pegged to current inflation rate. Interest is paid at regular intervals but cannot be withdrawn, hence compounding the amount earned over time.
Simple Example of a fixed interest Savings Bond
|Period of Savings Bond – 10 years|
|Fixed Interest Rate of 2% p.a.|
|10||239.02||12,189.95||Payable at maturity|
Advantages & Disadvantages of Government Bonds
|Risk Free or very Low Risk||Low rate of return|
|Treasury Bonds can be freely traded in the Open Market||Interest rate risk (fluctuations in interest rates may cause a decline in value)|
|Treasury Bonds are easily transferable||Savings Bonds cannot be traded in the open market|