What is a government bond?
Government bonds are an important component of a country’s financial structure and investors should understand what they are, how they work, and what kind of impact their performance can have in the economy and the stock market.
Let’s define government bonds while describing their most important characteristics.
A government bond is a fixed-income, security issued and backed by a country’s federal government.
These securities are commonly unsecured, meaning they are not secured by a specific asset, but rather by the reputation of the issuer. Although in some cases, like government-backed securities, they could be collateralised by a certain fixed asset.
Government bonds are backed by the full faith and credit of the issuing nation, which means that investors believe that the country will meet its financial obligations as expected.
These bonds are also known as sovereign bonds, although the government bonds meaning can be extended to government-backed issues, state issues, and even municipal issues.
How do government bonds work?
A government bond works in the same way as any other fixed-income security in the sense that they offer compensation through periodical coupon payments and/or by selling the issue at a discount of its par value, also known as zero-coupon issues.
These zero-coupon bonds are securities that do not offer any kind of interest payment. Instead, they are sold at a discount of their nominal value.
Meanwhile, coupon payments (if applicable) are usually distributed on a quarterly or annual basis and the nominal interest rate of government bonds is typically lower than that of corporate bonds although this is not always the case.
Types of government bond
Government bonds can be classified in many ways. The following is a list of the most common types of government bonds:
Fixed-rate bonds: a fixed-rate bond entitles the holder to receive a fixed annual interest rate on his investment regardless of the fluctuation in the country’s benchmark interest rate.
Variable-rate bonds: a variable-rate issue entitles the holder to receive an interest rate that fluctuates based on a predefined formula that includes a benchmark interest rate and a premium above that rate. If the benchmark rises, so will the interest rate applicable to the variable-rate bond and vice-versa.
Inflation-linked bonds: this type of bond was created to help investors in hedging against inflation risks by offering an annual interest rate that fluctuates alongside the country’s consumer price index.
Zero-coupon bonds: these bonds do not offer a periodical coupon payment. Instead, they are sold at a discount of their par value and the investor is compensated by obtaining a higher amount of principal once the bond matures.
Perpetual bonds: perpetual bonds have no maturity dates and commonly offer a fixed annual interest rate that is paid to the holder theoretically forever.
Government bond example
The United States has auctioned a total of $60bn in 10-year Treasury notes offering an annual interest rate of 1.2 per cent per year.
This means that investors who purchase these bonds will be entitled to receive a total of $720m in interest payment as compensation for providing the US government with funds for its operations.
Coupon payments will be disbursed every quarter – resulting in a quarterly payment of $180m, that will be distributed to investors based on the individual amount they had purchased. These bonds are only backed by the full faith and credit of the US government.