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What Are Government Bonds & How Do They Work?

May 7, 2022
8
min

The government can’t always collect enough in taxes to pay for everything right away. Bonds are used to cover the difference and refinance a government’s existing debt.

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Governments need to borrow money, just as people and companies do. All governments, no matter their size, need to pay for everything from daily operations to expensive long-term projects and public initiatives.

The government gets money mainly from people, corporations, and others that pay taxes. When tax revenue falls short, governments take on debt by selling bonds. A bond represents a loan. In this case, the borrower is a federal, state, municipal, or other government entity that issues the bond, and the lender is an investor who buys the bond.

What is a government bond?

A government bond is an agreement between the seller—a government—and investors who effectively act as lenders by agreeing to buy the bonds. In exchange for lending a government money, investors receive regular interest payments. These are usually fixed in nature and last for a specified period of time that ends when the bond matures. In the U.S., this can be anywhere from as short as a few days to as long as 30 years. Once the bond reaches maturity, the government repays the principal, or the amount of money investors had originally loaned to the government. 

Why do governments issue bonds?

Government can’t always collect enough in taxes to pay for everything right away. Bonds often are used to cover the difference. Bonds also refinance a government’s existing debt—repaying old debt that comes due with new debt. 

Central banks also use bonds to regulate a country’s money supply. For instance, the U.S. Federal Reserve sells bonds to decrease the cash circulating in the economy to rein in inflation. Conversely, the Fed buys bonds–thereby injecting the economy with more cash–when it wants to stimulate the economy. The Fed did this after the financial crisis of 2007-09 and during the COVID-19 pandemic.

What are the types of government bonds?

The two main types of government bonds are Treasuries and munis. The U.S. Treasury is the biggest issuer: the term “Treasuries” describes all U.S. sovereign debt across all maturities. Treasury debt outstanding was $23.2 trillion as of February 2022.

Cities, states, and other local governments issue municipal bonds known as “munis.” These bonds raise money for public purposes that tax collections and federal assistance don’t cover. The muni market had $4 trillion in debt outstanding as of the fourth quarter of 2021.

Both Treasuries and munis deliver regular interest payments and often come with tax advantages. Treasuries have virtually no risk of default because they’re backed by the full faith and credit of the U.S. government. Munis are not as low risk but have a negligible incidence of default because local governments can increase taxes to cover their debts. Treasuries and munis typically pay lower interest than corporate and other bonds in return for the reduced risk.

Treasury securities

Treasury securities, which are generally considered risk-free in terms of default, come with varying maturities. Some offer investors certain additional protections:

  • T-bills: These short-term securities mature in a few days to 52 weeks.
  • T-notes: Medium-term T-notes mature in two to 10 years.
  • T-bonds: This long-term debt matures in as long as 30 years.
  • TIPS: Treasury inflation-protected securities are indexed to inflation. The principal increases with inflation and decreases with deflation. TIPS are sold in 5-, 10-, and 30-year maturities.
  • FRNs: Floating rate notes carry interest payments that can change over time. When rates rise, interest payments increase; when rates fall, payments decrease. FRNs are indexed to the 13-week T-bill and mature in two years.

The Treasury also offers savings bonds to U.S. citizens. Individuals can buy them from the TreasuryDirect website or an authorized seller. Only the registered holder can receive payment; savings bonds can’t be sold on a secondary market as Treasuries can.

Savings bonds come in two varieties:

  • EE bonds: These bonds earn a fixed, government-set interest rate for 30 years. However, the Treasury guarantees that an EE bond will, in 20 years, be worth twice what the investor originally paid.
  • I bonds: These bonds earn both a fixed and variable rate of return. The fixed rate remains the same for the bond’s life; the variable rate changes every six months based on the U.S. inflation rate. I bonds also mature in 30 years.

Muni bonds

Smaller governments for states and local municipalities issue munis as either general obligation or revenue bonds. Both raise money for income-producing projects such as toll roads. Both are backed by the full faith of the issuer. They differ in the funding source used to pay the investor.

  • General obligation bonds: These muni bonds raise immediate capital without linking the money to a specific project. The issuer can repay the bondholders with any funding source.
  • Revenue bonds: These muni bonds pay for a specific project. The project produces the revenue that pays investors’ interest and principal.

Sovereign bonds 

Countries outside the U.S. issue bonds known as sovereign bonds or sovereign debt. Other national governments use these bonds for the same reasons the U.S. government does. Sovereign bonds can be denominated in a foreign currency, such as the U.S. dollar, or the government’s domestic currency. They carry risks unique to each country that include potential illiquidity, currency fluctuations, and a greater potential of default due, especially in developing nations subject to economic and political instability.

What affects government bond prices?

The U.S. Treasury determines the initial price and interest rate yield on its marketable securities by holding regular auctions. Bidders are generally big traders known as primary dealers who then offer the bonds to investors on secondary, over-the-counter markets.

Auction bidders may choose to pay the bond’s par amount, or face value. However, if the bond’s yield is attractive compared to other investments, or there’s more demand for it than supply,  bidders may bid up the price and pay more than face value. Conversely, if there is abundant supply or better alternatives elsewhere, investors may seek to pay less than par. 

When a new bond becomes widely available, several factors affect its price.

  • Interest rates: If interest rates are lower than the yield on the bond (called the coupon rate), demand for the bond is likely to increase. When demand for a bond increases, its price will rise. If interest rates rise above the coupon rate, demand may drop and the price of the bond will fall.
  • Maturity: Newly issued government bonds reflect current interest rates and usually trade close to par. Bond prices also tend toward par as they near maturity. A bond’s price is more likely to rise or fall in the middle of its term based on conditions at that time.
  • Inflation: Rising inflation is bad for bondholders, who are locked into fixed payments. Central banks often increase interest rates to rein in inflation. Higher rates mean falling prices for bonds as investors look elsewhere. Lower rates make bonds attractive, boosting prices.

Why are Treasuries important?

Treasuries play a key economic role that other bonds do not. Their unique importance affects their price.

The Federal Reserve buys Treasury bonds to stimulate growth because the purchases inject money into the economy. Bond prices are driven higher because the central bank must pay enough to convince holders to sell.

Conversely, the Fed can sell bonds to tame inflation by taking money out of the economy. In this case, the supply of bonds increases and their prices fall. The reduced supply of money becomes more valuable and interest rates rise. 

Treasuries also serve as a benchmark that determines how other interest rates are set. The 10-year Treasury note, or T-note, is particularly important. It serves as a benchmark for mortgage rates, corporate bond yields, and other financial calculations. It also reflects investor confidence. When confidence in the economy is high, prices for the 10-year drop and yields rise as investors look to other securities that can deliver higher returns. When confidence is low, bond prices rise and yields fall because safe, government-backed options become more attractive. 

Government vs. corporate bonds

Investors often compare government bonds with corporate bonds. “Corporates,” as they are called by traders, make up one of the largest components of the U.S. fixed-income market. Bonds let a company borrow from investors rather than sell stock, which dilutes equity and surrenders a measure of control to investors.

Compared to corporates and other bonds, government bonds have distinct advantages. They are:

  • Less volatile: Treasuries prices are generally less volatile than those of corporates and other offerings.
  • Tax exempt: Treasuries are usually exempt from state and local taxes, but taxed at the federal level. Munis are generally exempt from federal taxes and can be free from state and local taxes. Corporate bonds carry no tax exemptions.
  • Lower risk: U.S. government bonds face little or no credit, liquidity, or default risk. Corporate and other bonds generally are considered riskier.
  • Liquidity: The market for government bonds is massive, with a great deal of liquidity and transparency. Corporate bonds may be thinly traded.

Government bonds also have drawbacks when compared to corporate and other bonds. These include:

  • Lower returns: Government bonds generally offer investors lower returns to compensate for their lower risk. The effective yield for top-rated corporate bonds was 3.38% in mid-April 2022 while the 10-year Treasury yield was 2.79% 
  • Inflation risk: Government bonds’ comparatively lower, and fixed, interest rates are hurt when inflation rises. 
  • Less diversity: Government bonds fund broad programs such as infrastructure. Corporates let individuals select which industry or sector to invest in, as well as which issuer’s credit quality meets their risk tolerance.

The bottom line

Governments of all sizes sell bonds to fund daily operations and long-term projects from roads to schools. The U.S. Treasury issues bonds, collectively known as “Treasuries,” in a range of maturities to pay for the costs of the federal government not covered by tax receipts. These bonds are a virtually risk-free investment, though their prices can fluctuate with changes in interest rates and inflation. Treasuries serve the additional purpose of refinancing the government’s existing debt and regulating the U.S money supply. Bonds issued by the U.S. and other stable governments generally pay lower interest rates than corporate or other bonds.

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