What Is a Government Bond?

What Is a Government Bond?

Let me explain what a government bond really is—it's essentially a debt instrument that federal, state, and local governments issue to raise money for public spending. Think of it as an IOU from the government; when they need funds, they sell these bonds, and you, as the investor, become the lender. The government commits to repaying your full investment, which is the principal, on the maturity date. Along the way, you'll receive regular interest payments, often called coupon payments, typically at a fixed rate. This borrowed money goes toward things like social programs, healthcare, infrastructure, and even paying off existing public debt. You might choose government bonds because they provide a reliable, if modest, income stream and come with relatively low risk.

Key Takeaways

To sum it up quickly, a government bond is a fixed-income instrument that governments use to borrow money from investors. The funds support social programs, debt repayment, and infrastructure development. Overall, these bonds stand out for their safety and low-risk profile.

Types of Government Bonds

You'll find several types of government bonds, each suited to different needs. Municipal bonds, or 'munis,' are issued by local governments to finance things like infrastructure, libraries, or parks. They often come with tax advantages, such as exemptions, and can be backed by local taxes or project revenues, like from a toll road. These typically offer lower interest rates than riskier options like corporate bonds or stocks.

Then there are U.S. savings bonds from the Treasury, including series EE and series I. You buy them at face value with a fixed interest rate; hold an EE bond for 20 years, and it effectively doubles. Series I bonds add a semi-annual rate linked to inflation.

Treasury bills, or T-bills, are short-term, maturing from four weeks to 52 weeks. They're sold at a discount or face value, and at maturity, you get the full face value.

Treasury notes, known as T-notes, are intermediate-term, maturing in two, three, five, or 10 years, with fixed coupon payments. They usually have a $1,000 face value, except for two- or three-year ones at $5,000.

Treasury bonds, or T-bonds, are long-term, maturing in 20 to 30 years. They pay interest semi-annually, start at a $100 minimum, and help cover federal budget shortfalls while influencing the money supply and monetary policy.

Finally, Treasury inflation-protected securities, or TIPS, are indexed to inflation to shield you from rising prices. The principal adjusts with the Consumer Price Index—increasing with inflation, decreasing with deflation—and they mature in five, 10, or 30 years with a fixed interest rate paid every six months.

Bond Terms

You need to know some basic terms to navigate this. The face or par value is the amount you loan the government and what you'll get back at maturity. The coupon refers to the regular interest payments you receive. Yield is the effective interest rate, factoring in the bond's market price. Market price is what the bond trades for in the secondary market, which can differ from face value. And Treasuries specifically mean U.S. federal government bonds.

How to Buy Bonds

If you're holding government bonds to maturity, you get those regular interest payments plus your principal back. But prices fluctuate in the market—remember, bond prices move inversely with interest rates, so rising rates mean falling bond prices in the secondary market.

The U.S. Treasury sells bonds through auctions held throughout the year. Only registered participants, like big banks, can buy directly at these auctions. Buyers submit bids, and the process continues until all bonds are sold.

You can also trade bonds in the secondary market, where individual investors buy and sell existing ones. Treasuries are accessible via the Treasury, brokers, or ETFs that bundle securities.

Warning on Interest Rate Risk

Be aware that fixed-rate government bonds carry interest rate risk. If rates rise while you're holding a lower-paying bond, your real return diminishes. For example, a 2% bond in a 1.5% inflation environment nets you just 0.5% in real terms.

Foreign Government Bonds

U.S. Treasuries are seen as nearly risk-free, often used as benchmarks for other securities' risk and for setting lending rates, like the 10-year Treasury. But bonds from other countries can be riskier, especially in emerging markets, due to regional, political, and central bank issues. The 1997-1998 Asian financial crisis showed this when currency devaluations caused global fallout.

Pros and Cons of Government Bonds

Government bonds have clear upsides and downsides for you as a bondholder. They deliver a steady interest income, though usually lower than higher-risk options due to their safety. The U.S. bond market is highly liquid, making resale easy in the secondary market, and you can access them through ETFs or mutual funds focused on Treasuries.

On the flip side, fixed-rate bonds can lag during inflation or rising rates. Foreign bonds add risks like sovereign default, currency changes, and higher default chances.

How Do Investors Buy Government Bonds?

You can get U.S. Treasury securities through your broker, bank, or the TreasuryDirect website. Also consider ETFs or mutual funds that invest in Treasuries. For municipal bonds, go through a broker.

How Does the U.S. National Debt Relate to Bonds?

The U.S. national debt is mostly the total value of outstanding government bonds. About $28.2 trillion is publicly held, with $7.1 trillion in intragovernmental holdings, totaling around $35.3 trillion as of Q3 2024.

How Does the Federal Reserve Use Bonds for Monetary Policy?

Government bonds fund budget deficits and projects like infrastructure. The Federal Reserve uses them to manage the money supply—repurchasing bonds injects money into the economy as sellers spend or invest, and banks lend more, boosting activity.

What Are Examples of Non-U.S. Government Bonds?

Foreign governments issue bonds too, such as U.K. Gilts, German Bunds, French OATs, and Japanese JGBs.

The Bottom Line

In essence, government bonds offer a risk-free rate of return but with lower yields. In the U.S., they're called Treasuries; abroad, similar instruments exist. State and local governments issue municipal bonds, often with tax exemptions.