What Is a Government Bond?

What Is a Government Bond?

A government bond is a debt security issued by a government to support spending and obligations. Government bonds pay bondholders periodic interest payments called coupon payments. Government bonds issued and backed by national governments are often considered low-risk investments. Government bonds issued by a federal government are also known as sovereign debt.

Types of Government Bonds

• Municipal Bonds: Local governments issue municipal bonds to fund infrastructure, libraries, or parks. These "munis" often carry tax advantages and exemptions for investors. Munis may be supported by local tax dollars or revenue from a project like a toll road. Municipal bonds commonly provide investors with lower interest rates than riskier investments like corporate bonds or stocks.
• U.S. Savings Bonds: The U.S. Treasury offers series EE bonds and series I savings bonds. Bonds sell at face value and have a fixed rate of interest. Bonds held for 20 years will reach their face value and effectively double. Series I bonds receive a semi-annually calculated secondary rate tied to an inflation rate.
• Treasury Bills (T-Bills): Short-term securities from four weeks to 52 weeks. Bills are sold at a discount or face value. When the bill matures, investors are paid its face value.
• Treasury Notes (T-Notes): Intermediate-term bonds maturing in two, three, five, or 10 years that provide fixed coupon returns. Treasury notes (T-notes) typically have a $1,000 face value. However, two- or three-year maturities have a $5,000 face value.
• Treasury bonds (T-Bonds): Long-term bonds with a maturity between 20 to 30 years. Treasury bonds (T-Bonds) give interest or coupon payments semi-annually and have a minimum investment of $100. The bonds help to offset shortfalls in the federal budget. Also, they help to regulate the nation's money supply and execute U.S. monetary policy.
• Treasury inflation-protected securities (TIPS): Indexed to inflation, Treasury inflation-protected securities (TIPS) protect investors from the adverse effects of rising prices. The par value, or principal, increases with inflation and decreases with deflation, following the Consumer Price Index (CPI). These securities with maturities of five, 10, or 30 years, pay a fixed rate of interest determined on the bond's auction on a six-month basis.
  

Bond Terms

• Face or Par Value: the amount of debt bondholders loan the government and the amount they will get back when the bond matures
• Coupon: the regular interest payments credited to bondholders
• Yield: the interest rate on the bond after accounting for its market price
• Market Price: the price of the bond in the secondary market, which may differ from the face value
• Treasuries: U.S. federal government bonds

How To Buy Bonds

Investors who buy government bonds and hold them until maturity enjoy regular interest payments and a return on their initial investment. The price of a government bond will fluctuate in the market. Bond prices have an inverse relationship with interest rates⁠—so when interest rates go up, government bond prices go down in the secondary market.

The U.S. Treasury Department sells issued bonds during auctions throughout the year. Only certain registered participants, often large banks, can buy U.S. government bonds directly at auction. When the government holds a bond auction, each buyer submits its purchase bid, and the auction continues until all the bonds are duly distributed.

Some bonds are traded in the secondary market. Individual investors can buy and sell previously issued bonds through this marketplace. Treasuries are widely available for purchase through the U.S. Treasury, brokers, and exchange-traded funds (ETFs), a basket of securities.

Foreign Government Bonds

U.S. Treasuries are regarded as nearly risk-free investments, however, those floated by other countries may carry a greater degree of risk. Due to this risk-free nature, market participants and analysts use Treasuries as a benchmark in comparing the risk associated with securities. The 10-year Treasury bond is also used as a benchmark and guide for interest rates on lending products.

Other government-backed bonds, particularly those in emerging markets, carry regional, political, and central bank risks. Investors saw a bleak reminder of how risky some government bonds can be during the Asian financial crisis of 1997 and 1998. During this crisis, several Asian nations were forced to devalue their currency, which sent reverberations around the globe.

Pros and Cons of Government Bonds

Government bonds provide both benefits and disadvantages to the bondholder. These debt securities tend to return a steady stream of interest income. However, this return is usually lower than other products on the market due to the low level of risk.

The market for U.S. government bonds is very liquid, allowing the holder to resell them on the secondary bond market easily. Some ETFs and mutual funds focus their investment on Treasury bonds.

Fixed-rate bonds may fall behind during increasing inflation or rising market interest rates. Also, foreign bonds are exposed to sovereign or governmental risk, and changes in currency rates, and have a higher risk of default. 

The Bottom Line

Government bonds carry a risk-free rate of return but come with lower yields. In the U.S., federal bonds are known as Treasuries. Foreign governments also issue bonds. State and local governments issue municipal bonds that may offer certain tax exemptions.