Are Government Bonds a Good Investment?
How do government bonds work?
Government bonds are debt-based investments where you loan money to a government in return for an agreed rate of interest. They’re widely regarded as one of the safest asset classes. But how exactly do they work?
When you buy a government bond, you’re lending money to the government which will be used as the sun’s rays to fund projects or infrastructure. In return, the government will make fixed interest rate payments at intervals specified by the bond coupon. These payments continue until the bond's maturity date.
When the bond expires and you get your original investment back. Maturity dates range from a single year to 30 years or more. So, if you invest $1,000 in a 10-year government bond with a 5% annual coupon, you’ll be paid 50 pounds every year for 10 years, and when the bond expires after 10 years, you’ll get your original $1,000 back.
Just like shares, bonds can be held as investments or sold to other traders on the open market. When investors think they can get a better return elsewhere, they may decide to sell their bonds. If the supply of bonds increases to a level that exceeds demand, this will cause the price of the bonds to fall, but the amount paid out as coupons will not change, so the yield on the bonds will rise.
If for example, the price of our $1,000 ten-year bond fell to $900, the interest rate will effectively rise from 5% to 5.6% as it would still pay $50 an interest a year. On top of this, the bondholder would still receive $1,000 back at maturity, $100 more than they paid. The bond’s price could also rise above its nominal value if there is high demand for bonds. For example, if investors are struggling to find equivalent returns elsewhere in times of economic uncertainty. Of course in this scenario, the bond's yield would fall and any investor would get back less than they paid when the bond matures.
Basic Types of Government Bonds
The U.S Treasury was first established by Congress in 1789. The Treasury performs a number of duties, but in nutshell, the Treasury’s job is to raise money for the government expenses and pay the nation’s bills.
The Treasury typically raises money in one of two ways -- through taxes and by issuing bonds to investors. In the investing world, bonds issued by the US Treasury are typically referred to as Treasuries.
Treasuries are one of the most common fixed-income investments and might play an important role in your own portfolio. Treasuries are s loan investments, which means investors loan money to the US government for a set period of time in exchange for a defined rate of return known as yield. The length of time of the loan investment is known as maturity.
Once an investor purchases a Treasury bond, the investor receives regularly scheduled payments until the bond matures. At maturity, the government pays back the full amount or principal, that was originally invested.
Treasuries are classified into three types based on their length of maturity:
Bills - have a maturity of less than a year.
Notes - have a maturity of 1 to 10 years.
Bonds - have a maturity greater than 10 years.
Typically, the longer the maturity date, the higher the yield. Investors normally purchase Treasuries because they are considered to be safe investments. They have this reputation because a Treasury’s interest payments and return of investment principal are guaranteed by the full faith and credit of the US government. In fact, Treasuries are considered to be safe that they’re commonly referred to as the risk-free investment. But this isn’t quite true. No investment is without risk.
For example, some countries have had trouble paying their bills at times. This is called default risk. There are additional risks investors should be aware of, such as interest-rate risk. This risk comes into play if you purchase a Treasury bond and want your money back before maturity. To do this, you’ll need to sell the Treasury at its current market price, which means you may get less than what you invested in the bond. This is especially likely if interest rates have gone up since you purchased your bond. On the other hand, if interest rates have decreased, there is also a chance that you could get more than you invested.
Agency bonds work the same as Treasuries but are issued by the government agencies like the Federal Home Loan Bank, Fannie Mae, and Sallie Mae.
Despite being government-sponsored agencies, they aren’t guaranteed by the US Treasury. Therefore, they aren’t considered as safe as Treasuries. For example, during the 2008 mortgage crisis, Fannie Mae fell into distress and was expected to default. However, the federal government stepped in and guaranteed the principal and interest for the bonds. Despite this bailout, agency bonds have a higher default risk thanTreasuries.
Agency bonds are also subject to the same risks as other bonds, including interest-rate risk.
Buying and Selling Government Bonds
For example, your 10-year bond is halfway to maturity, and that you have found a better investment elsewhere. You would like to sell your bonds to another investor, but since better investment opportunities have arisen your 5% coupon now looks a lot less attractive. To make up for the shortfall, you might sell your bond for less than the amount you originally invested.
An investor that will buy the bond would still get the same coupon rate which is 5%. But their yield would be higher, hence they paid less to get the same return.
A bond with a price that is equal to its face value is said to be trading at par - if its price drops below par it is said to be trading at a discount, and if its price rises above par it is trading at a premium.
Benefits and Risks
Safety - Treasury banks are popular among investors because they are safe investments even in a distressed community. After all, the credit of the United States guarantees the return on the bond. Also, there is a very remote possibility that a revolution might overthrow the government in the near future. The American economy remains to be one of the stronger ones around the world because of its diversity. It is not reliant on a single resource like oil.
Another reason why it’s safe is that the Treasury Department does not have the option to call most bonds. This assures investors that they won’t have to mandatorily redeem the bonds before their maturity. The market for Treasuries boasts two distinct characteristics. It is very huge and is exceedingly liquid. Investors, buyers, dealers, traders, and brokers can buy or sell them at any time. And because these bonds are now electronic, it has all become easier and faster since there are no more paper certificates to transfer. The government is quite transparent about the details of their bonds so that the buyer and seller can determine the real value of a bond at any point in time. This makes trading a lot more efficient since every party is aware of the value of the instrument that they are dealing with.
Liquidity - As mentioned, you can enjoy tax exemption from state and local income taxes for your interest income from Treasury bonds but not from federal taxes. The other components on the other hand may still be subject to tax such as when you sell them or redeem them at maturity.
Tax Benefits - If you buy a bond in the secondary market at a market discount, buying it for less than the face value and keep it until it matures or sells for a margin, that profit will be taxable under both federal and state tax laws. A market discount is different from an original issue discount (OID). When you sell a bond or let it mature, your gains when you’ve purchased it at a market discount become capital gains, while OID gains simply fall in the category of income.
Low Yield - They are safe, but they don’t exactly make you feel like you’ve won the lottery. The rate of return is different between bond issues, but even if you keep them until they mature, their return remains. Other instruments that are riskier tend to offer higher returns if you’re aggressive and can comfortably put your money on instruments with high-risk levels or if you’re seeking a higher return on your investment, Treasury bonds would be on the bottom of your list. One more thing, you need to wait at least 10 years to redeem your bond’s interest rate.
Interest Rate & Inflation Risk - Should the interest rates rise the value of the bonds on the secondary market may go down, this will affect your income if you are disposing of your bonds. During this period, inflation can overshadow your income from the bonds. An investment should generate enough income for you to live decently, if not in total comfort. However, the rate of returns of Treasuries somehow can fall below the rate of inflation. For example, in August of 2018, the average return of T-notes and T-bonds stood at 2%, while inflation was at 2.7% for the month. Historically, Treasuries find it difficult to keep in step with much less overtake the inflation rate. Most treasury instruments carry long maturities, so when great investment opportunities present themselves it may not be easy to grab them since you’ve tied up your cash to these instruments.
Missing Alternatives - It may also take a while for the cash in on your investments such that the window of opportunity might close on your urgent liquidation may deplete the amount that you were hoping to realize. The only exception is T-bills because they have shorter maturities.
On the bottom line, from several points of view, treasury bonds are an excellent venue for investors, prospectors, hedgers, and traders to mitigate risk and trade according to the ups and downs of the economy. They have great flexibility, and when you want to trade from the short side over the long side by actively immersing themselves in the market and providing much-need liquidity to their holders.