Investing can be a risky business, and how you decide to invest will depend on your appetite for risk. Government bonds are generally considered a lower-risk option than investing in the stock market or putting money into corporate bonds.
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While returns are capped, hence the term “fixed-income”, with the correct analysis, it’s possible to make relatively low-risk returns superior to those associated with holding cash in a savings account. Investing in government bonds offers additional stability but doesn’t mean holding bonds is an unexciting process. The way they balance a portfolio can make possible the inclusion of some higher-risk positions which have the potential to outperform and boost aggregate returns.
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Government Bonds Explained
With the financial markets continuously throwing up surprises, it’s hard to move too far from the orthodox position that allocating a specific percentage of capital to bonds helps investors develop a well-diversified portfolio. This is because of the way bonds work.
The simplest way to explain the mechanics of bond trading involves an investor who buys a bond on the day it is issued in the primary market. The bond’s lifespan will be determined by the maturity date, which is when a bond redeems, and the bondholder is refunded their initial investment.
The maturity dates of government bonds vary, but popular terms are one year, three years, five years, and ten years. The range of dates means investors with different investment ambitions are catered for, and the bond issuer will find more buyers interested in their offering.
At stated intervals, coupons will be paid to bondholders. These represent the interest payments made to investors and reward bondholders for loaning the bond issuer capital. Coupon payments of medium and long-dated government bonds are typically paid every six months or annually.
One example would be a 2-year bond sold on the issue date for $100. That is called the bond’s par value, and it pays an annual coupon of $5. The effective interest rate on that bond is 5%, with coupons paid at the end of years one and two. The second coupon date would coincide with the maturity date, and the investor will receive $5, which is also when their initial $100, the principal amount, will be returned.
Being tied into a loan agreement for two years could be disadvantageous for investors who might, over those two years, experience a change of circumstances and want to realign their portfolio. As a result, a secondary market exists which facilitates those who want to buy and sell bonds at any point in a bond’s life.
The secondary market also factors in how market conditions and investor sentiment change over time. If, for example, geopolitical events result in the bond issuer being seen as having a higher credit risk, demand for their bonds will be reduced. Following the fundamental laws of economics, the bond price will fall, meaning secondary buyers will receive a higher yield. If in our example, the bond falls in price to $90, the rate of interest a buyer stepping into the market at that point would receive would rise to 5.5%. Anyone who bought in the primary market will still receive a 5% yield, but latecomers would receive additional rewards for factoring in the increased risk of losing all their money.
Bond market news reports often refer to the yield rather than the price of bonds because the interest return is essentially the main reason investors are drawn to the market.
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What Factors Determine Bond Yields
The perceived creditworthiness of the bond issuer is one of the main influences on bond yields. In most cases, government bonds are thought to be an investment that is very low risk. Why? Because it is assumed that it would be improbable that a government would go bankrupt and therefore not be able to pay back the interest due on the loan or repay the loan in full when it became due.
When considering buying government bonds, it’s important to remember that the worst-case scenario that a default occurs is unlikely. Regardless, changes in governments and other risks can result in yields rising and falling.
Another factor which influences bond yields is the lifespan of a bond. A government which issues 2-year and 10-year bonds will often offer a higher return on the longer-dated bonds. The credit risk of the issuer is the same for holders of both bonds, but the differential meets the needs of the issuer, who will be keen to encourage investors to tie their money up for longer.
The underlying health of a country’s economy can also influence bond yields. A high inflation rate is usually bad news for bondholders because the rising prices eat into the fixed returns stipulated by the coupon rate. Holding bonds becomes less attractive if the $5 return in two years is, in real terms, worth less. As a result, bond prices in the secondary market can be expected to fall so that yields rise to counterbalance the impact of inflation.
Why Bond Yields Are Important
Bond yields can help investors build a portfolio to meet their investment needs. However, another reason to follow the bond markets is that they can offer an insight into market developments which might impact other types of assets they hold.
An inversion of the bond yield explains a situation where trading in the secondary market results in higher yields on shorter-dated bonds than those of longer-dated ones. This anomaly is explained by market sentiment moving to be more risk-averse. More importantly, historical data points to inversions in bond yields being a leading indicator of a recession and can be followed by investors reducing their exposure to equities.
Types of Government Bonds
The willingness of governments around the world to run budget deficits and spend more than they receive in tax revenues means there is a global market in government bonds. These bonds are known as gilts in the UK, Treasuries in the US, and Bunds or Bobls in Germany.
Government bonds are often categorised by maturity date. Short-dated varieties such as the 4-month US T-bills help governments manage immediate cashflow issues. In contrast, US T-bonds can have maturity dates of 30 years and provide more stable financing for long-term projects.
As of June 2022, the amount of US government debt issued in the form of bonds totalled $23trn. Over half of those were Treasury Notes with maturities of two, three, five, seven or ten years. The remainder of the total comprises shorter-dated T-bills and long-maturity T-bonds.
Governments also offer bonds with floating rates of return. In the UK, gilts that are index-linked pay interest linked to the Retail Prices Index (RPI). As the way these hedge against the risk of inflation appeals to investors, other governments also offer them with the US version of variable interest rate bonds known as FRNs (Floating Rate Notes).
It is also worth considering government bond futures which are another way to trade bond price moves. These derivative instruments aren’t issued by governments, but they track moves in the underlying government-issued assets. They are available at good brokers and have functionality which can appeal to those looking to take a short-term position for hedging or speculation purposes.
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How to Research and Buy Government Bonds
If you’re looking to buy government bonds, it might suit your investment aims to consider bonds from different countries worldwide. Your analysis should assess the creditworthiness of the governments in question. In addition, as non-index-linked bonds pay fixed returns, your strategy should also factor in whether future inflation is likely to be higher or lower than expected, as that will determine the ‘real’ return.
Research can draw on the reports of specialist agencies such as Standard & Poor’s, which analyse the fundamental health of a country’s economy and the levels of government borrowing. You could also compare what support different brokers can offer you through a broker comparison.
Those same brokers are an obvious choice when deciding how to trade government bonds. Good brokers offer a wide range of international government bond markets and competitive pricing schedules to ensure administration costs don’t erode client returns.
Investing in a government bond ETF is another option. These user-friendly fund-style vehicles, which brokers offer, provide a chance to buy a basket of different bonds with the click of one button. ETFs diversify exposure, smooth out returns, and are cost-effective. They can also be bought and sold at any time that the market is open, meaning investors don’t have to wait for a month-end dealing day to adjust their portfolio.
Buying from the bond issuer directly can have its advantages. The government Debt Management Office in the UK and Treasury Direct in the US sell bonds directly to smaller investors. These are the only products these bodies offer, so a separate account will need to be created.
Advantages of Buying Government Bonds
When you buy government bonds, you enter as close to a risk-free investment environment as possible. The return, expressed as a coupon or interest rate, will vary depending on which government is the issuer. Governments perceived to have a higher risk of default need to compensate investors by offering a higher rate of return, but there are plenty of good reasons to buy bonds which include:
- Low risk of default: Government bonds provide a relatively safe haven for the principal you invest and the regular interest you receive. You can invest in bonds with different maturities, so you can look to a long-term strategy or look for shorter-term gains safe in the knowledge that both are relatively safe.
- Tax treatment: Depending on where you invest, there can be advantages to holding government bonds. For example, if you own UK government gilts directly, you will incur no capital gains tax on your investment.
- Portfolio diversification: Holding a percentage of your total capital in bonds can facilitate some being allocated to riskier investments. For example, a portfolio with a 100% allocation to equities would be closely tied to the ups and downs of the stock market and may therefore focus on low and medium-risk stocks. One with some bond allocation frees up room for some equity positions to be of higher risk.
- Higher level insight: Bond market analysts often carry out a more detailed and longer-term approach to studying market trends. This can help investors build a ‘macro’ view which is complementary to the analysis carried out in the equity sector, which tends to be stock specific.
The main upside to government bonds of stable economies is the much lower risk of losing your investment. They help investors diversify exposure which can smooth our returns and make it easier to hold onto higher-risk positions during periods of market uncertainty. The returns on government bonds may well be lower during boom years, but they help meet the aim of ensuring that a portfolio posts long-term gains.
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Disadvantages of Buying Government Bonds
Traditional investment advice has guided investors to invest approximately 30% of their capital in bonds. That offers a degree of security and stability, but there are good reasons why that percentage isn’t higher for most investors.
- Risk of interest rates: Buying government bonds usually involves little or no chance of default on your loan, but as bonds are traded on the open market, they could lose value if interest rates rise beyond the face value of the bonds. Therefore, as bond prices move in the opposite direction to the way interest rates have gone, the price of the existing bonds drops. However, if interest rates fall, then the value of bonds is likely to rise.
- Unexpected events: Though bonds are generally reckoned not to be at risk of default, there can be shifts in markets of specific bonds – especially in US municipal bonds – that could default, so take care when choosing your investments.
- Opportunity Cost: Cash tied up in bonds could be allocated to other asset groups, potentially generating superior returns.
When you buy government bonds, you are entering as close to a risk-free investment environment as possible. However, if you choose to invest in bonds with governments that may not be economically or politically secure, you could have a higher risk to your principal investment. Even though the interest rate may be high in relation to a safer place for your money, you should consider if you are willing to take on those risks. By developing your investing and trading strategies with an experienced broker, you can decide your risk appetite to build up a diverse investment portfolio.
Government Bonds – A Good Investment Strategy?
Investing is rarely risk-free. You could put all your cash into a bank’s savings account and watch a very low-interest rate effectively eat your money away as inflation takes its toll. Government bonds, especially UK gilts and US Treasuries, may not be completely free of risk but are as secure a way to get some growth for your money as anything else.
It depends on what you are looking for. Depending on the maturity dates of investments, long-term growth can provide a reasonable return, and you can be as sure as possible that your principal will be returned as well. Explore various options, talk to brokers or investigate online, and understand your best options. A diverse portfolio with gilts gives you a mix of low and high-risk options, all of which could grow your capital.
While the stock market might grab the headlines, it is often fixed-income traders and bond prices which determine the direction the broader financial markets take. That is because bond traders typically take a longer-term view, which is also due to the comparative size of the two sectors. The US stock market’s total capitalisation, for example, typically being smaller than the combined amount of US government and corporate debt.
The term ‘masters of the universe’ was coined to describe bond traders and their far-reaching influence. It explains why understanding events in fixed-income markets forms a vital part of any strategy. Holding bonds brings many benefits to investors, but even out-and-out stock traders would do well to devote time to following events in the bond market.