How do government bonds work?
A government bond is how governments raise money to fund public expenditure, besides taxes. If you purchase a bond for say, 100 euros, the government which issued the bond promises to pay you regular interest and the principle (also known as face value) of the loan back, in this case €100, at a future date, known as the maturity date (or redemption date).
What are the advantages of government bonds?
- They are guaranteed by governments, which rarely default on their loans because doing so greatly increases their borrowing costs and can mean that they may struggle to fund their expenditure at all. There is a big difference in risk between government bonds guaranteed by low inflation, first world countries with the ability to print money, and government bonds offered by developing countries, many of which have a higher inflation rate and a greater risk of default. These countries generally have to offer higher interest rates in order to attract investors. Some countries are also less able to “print” money, such as Eurozone countries, although the European Central Bank often creates new money.
- The interest rates are fixed at the outset, which means when market interest rates fall, the value of existing government bonds tends to increase.
- Many governments only provide limited guarantees in case of a bank defaulting on their cash accounts, such as the first €100,000 per person and per bank account in France, or €250,000 in the US. A bank is normally more likely to default than a government.
- Different maturities are available and these can be matched to liabilities, for instance: if a debt is due to be repaid in 12 months time, then rather than leaving the funds in a cash account, the company or individual could purchase a 12 month government bond. Pension funds and life insurance companies often purchase 30-year government bonds which are more suitable for their longer-term liabilities.
- Bonds are available from almost every country and in almost every currency, providing different levels of risk, interest rates, maturities and sometimes inflation protection. The fact that they are available in different currencies also makes them useful for liability management and hedging.
- Their values often go up when the stockmarket goes down, which is attractive for investors who fear a fall in share prices.
- There are tax incentives for some government bonds
- They are generally easy to resell.
What are the disadvantages of government bonds?
- Inflation can erode the returns of the bond. If a 30 year US government bond (known as a Treasury bond) has a face value of 100 US dollars then we can be fairly sure of receiving the 100 dollars in 30 years, but how much will 100 dollars be worth in 30 years time? Might we have been better investing into something else? However, Inflation-linked bonds also exist, such as Treasury Inflation-Protected Securities (TIPS) in the US.
- The value of existing government bonds generally fall when central bank interest rates increase because their interest-rates are fixed and cannot rise with the matching market interest rates.
- Their value before the redemption date can fluctuate just as much as stocks as they are highly sensitive to central bank monetary policy decisions such as central bank interest rate changes and money creation programs such as quantitative easing.
- Their long-term expected returns are generally lower than corporate bonds and shares, due to their lower levels of risk (in general)
- Their values generally go down when stockmarkets are expected to rise as governments are less likely to cut interest rates and there is more likely to be inflation. This partly explains why there has been a global rout in government bonds.
How can I invest into government bonds?
Either directly or via investment funds. Buying government bonds directly is more suitable for liability management and hedging, for instance, to earn interest before a large tax bill or before a creditor or supplier needs to be paid. Government bond funds or even simply cautious investment funds can be more cost effective than buying individual bonds and are often more suitable for smaller investors and for those who are not saving for a future cash liability. Investment funds benefit from greater diversification.
How can Aisa International help you?
Aisa International can provide you with diversified risk-rated and multi-asset portfolios, which can contain government bonds. We can also arrange for the direct purchase of government bonds for clients with investment portfolios worth at least €1 million.
The views expressed in this article are not to be construed as personal advice. Therefore, you should contact a qualified, and ideally, regulated adviser in order to obtain up-to-date personal advice with regard to your own personal circumstances. Consequently, if you do not, then you are acting under your own authority and deemed “execution only”. Additionally, the author does not accept any liability for people acting without personalised advice, who base a decision on views expressed in this generic article. Importantly, this article is dated and is based on legislation as of the date. It should be noted that legislation changes, but articles are rarely updated. Sometimes a new article is written; so, please check for later articles. Additionally, check for changes in legislation on official government websites. Finally, this article should not be relied on in isolation.
