Government bonds

Definition

Government bonds are debt securities issued by a government to support government spending and obligations. They are typically seen as low-risk investments since they are backed by the full faith and credit of the issuing government. Investors often use them as a way to earn interest income while preserving capital, making them an essential component in understanding different types of fixed income securities, bond pricing, yield measures, and management strategies.

5 Must Know Facts For Your Next Test

1. Government bonds can have various maturities, typically ranging from short-term (like Treasury bills) to long-term (like Treasury bonds).
2. They usually offer lower yields compared to corporate bonds due to their reduced risk.
3. Interest from government bonds is often exempt from state and local taxes, making them attractive to investors in high tax brackets.
4. Changes in interest rates affect the prices of government bonds inversely; as rates rise, bond prices generally fall and vice versa.
5. In the context of bond management strategies, government bonds can be key components for both active and passive strategies due to their liquidity and stability.

Review Questions

• Compare and contrast government bonds with corporate bonds regarding their risk profiles and investor appeal.
  • Government bonds are considered safer investments compared to corporate bonds because they are backed by the issuing government's ability to raise revenue through taxation. Investors often favor government bonds during uncertain economic times due to their lower credit risk. In contrast, corporate bonds typically offer higher yields to compensate for their higher risk, as corporations may default on their debt obligations. The appeal of government bonds lies in their stability and tax advantages.
• Discuss how changes in interest rates can impact the pricing of government bonds and what this means for investors.
  • When interest rates rise, the prices of existing government bonds tend to decrease because new bonds are issued at higher rates, making older bonds less attractive. This inverse relationship between interest rates and bond prices means that investors holding long-term government bonds may face capital losses if they sell before maturity. Conversely, when interest rates fall, existing bond prices increase, benefiting those who hold these securities as their market value rises.
• Evaluate the implications of using government bonds within active versus passive bond management strategies.
  • In active bond management strategies, portfolio managers may take advantage of fluctuations in government bond prices based on interest rate forecasts or economic indicators. They might buy or sell these securities opportunistically to maximize returns. On the other hand, passive bond management strategies focus on maintaining a fixed allocation of government bonds in a portfolio to track a specific index, aiming for steady income rather than high returns. The choice between these strategies reflects different investor goals related to risk tolerance and market expectations.

Related terms

Treasury bonds: Long-term government bonds issued by the U.S. Department of the Treasury with maturities ranging from 10 to 30 years.

Coupon rate: The interest rate that the issuer of a bond agrees to pay bondholders, typically expressed as a percentage of the face value of the bond.

Credit risk: The risk that a bond issuer will default on their payment obligations, which is generally lower for government bonds compared to corporate bonds.