Have you wondered how the Federal Government finances its activities? Taxes are one way, but did you know the government also takes on debt by selling bonds to the people and other nations? Government bonds, also known as sovereign bonds, are debt obligations issued by the national government and are great for deloading some of your portfolio’s risk.
There are a few different types of government bonds, such as treasury bills (T-Bill) or treasury inflation-protected securities (TIPS). All bonds issued by the government are fully backed by, you guessed it, the government, and are commonly labeled as “low-risk,” or “risk-free” in a treasury bill’s case.
How do Government Bonds Work?
Government bonds act very similarly to other types of bonds. Debt securities are an IOU between the issuer and investor, sound simple enough, right? Unfortunately, the IOU is more defined than how you would Venmo your friend for the weekend’s bar tab.
These IOUs, or bonds, have defined characteristics to them such as present and future value, interest earned (coupon rate), interest payment schedule (coupon payment), and when the money is due (maturity date). Since the return is defined in advance, bonds are considered fixed-income securities. Aside from the interest earning benefit, government bonds also offer tax incentives to their investors. Interest earned from these bonds are exempt from federal and income taxes.
Let’s take a look at an example of how they work.
Government Bond Example
Suppose you’re presented with an opportunity to invest in a hypothetical $1,000 Treasury Note (T-Note) with a 10-year maturity date, 2% annual interest, and bi-annual coupon payments. If the investor was to agree on these terms and purchase this T-Note, they would earn $10 every six months [($1,000 x 2%) / 2] for 10 years. After 10-years of holding this bond, the investor would have earned $200 from interest, as well as receive their original principal payment of $1,000.
Types of Government Bonds?
There are multiple types of bonds that the government will issue. Each has their own unique features, for example treasury bills are short-term bonds with a maximum maturity date of 52-week while treasury bonds mature in 20 or 30 years. A common feature amongst all government bonds is that Interest is taxed at a federal level, but not at state or municipal level. It is very easy to get them mixed up, so let’s take a closer look below.
As mentioned before, treasury bills are shorter term bonds with maturity dates. This can range from 4, 8, 13, 26 and 52 week. T-bills are usually sold at a discount to par (face value) to attract investors. Per TreasuryDirect, it is very rare for these bonds to be sold at face value. The interest earned on the discounted t-bill is the difference between the face value and what you paid.
For example, if you bought a $100 face value t-bill for a discounted price of $90, the interest earned at maturity would be $10 (face value – discounted price). .
Treasury notes, or T-Notes, have longer maturity periods than t-bills. Maturity dates can range for 2, 3, 5, 7, or even 10 years. T-notes earn interest, and coupon payments are paid out bi-annually.
Depending on the note’s maturity and coupon rate, these bonds can be sold at a discount or premium to par. For example, if the yield to maturity (YTM) is less than interest, it will be sold at discount. If the YTM is greater than the interest rate, it will be sold at a premium. Can you guess what the bond will be sold at if YTM is equal to the interest rate? The answer is it will be sold at par!
Treasury bonds are longer term investments, and have 20 to 30 year maturity dates. Each bond’s interest and price are established at the auction date. Because these bonds have a longer timeframe, the interest rate is typically the highest amongst its relatives, t-bills and t-notes. Treasury bonds pay interest to their holders every 6 months.
Treasury Inflation-Protected Securities (TIPS)
TIPS are very different from other government bonds. First off, the major benefit of these securities is in its name, it protects the investors from inflation risk! As inflation increases, the principal value of the TIPS increases as well. Let’s look at an example of how this works.
If you purchased a $100 face value TIPS with a 2% coupon rate, and inflation rises an absurd amount of 5%. The TIPS’ face value of $100 would increase 5% to $105. This also means that your interest payment will increase as inflation rises.
Treasury Inflation-Protected Securities have maturity dates of 5, 10, and 30 years, and interest is paid at the end of maturity.
Floating Rate Notes (FRNs)
FRNs, also called, “floaters,” are newer securities offered by the U.S. Treasury department. They earned the nickname due to their varying coupon rate. Interest rate on floaters is calculated by adding the index rate and spread. These securities have a two year maturity and pay interest quarterly.
How to Buy Government Bonds
Government bonds can be purchased directly from the government, for as low as $100 through TreasuryDirect, or through your brokerage, such as Fidelity or TD Ameritrade. The U.S. Treasury announces their auction dates and respective offerings in advance. Check out an example from earlier 2020 below:
It is important to remember that bonds are fixed income investments, and offer stability and risk protection with your investments. Compared to equities, bonds are much safer investments. Government bonds are backed by the full faith and credit of the national government, making them “risk-free,” and a great addition to your portfolio.