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Government bonds are widely considered as one of the least risky investments available to many investors. Read this article and learn all about government bonds including what they are, how they work and how to take a position in them through our trading platform.
A government bond is a debt-based instrument that involves lending money to a government at an agreed rate. Governments would then use them to earn money that can be spent on new projects and infrastructure, and investors can use them to earn a regular, consistent rate of return.
In America, government bonds are called Treasuries. In England they are called Gilts. All investments involve risk, but government bonds from established and stable economies are considered relatively low-risk investments.
Buying a government bond means lending an agreed amount to the government for an agreed period of time. In return, the state periodically reimburses fixed interest payments called coupons. This makes the bond a fixed income asset.
When the bond expires, the original investment amount, called the principal, is returned. The date on which the capital is received is known as the maturity date. Bonds come in a variety of maturity dates, which indicates the amount of time the borrower will hold on to the capital and pay out coupons for. Maturity dates can range from between less than a year to over 30 years.
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Maturity refers to the bond’s time till it expires, also the time to which the final payment is made. In other words, it is also the bond’s active lifespan.
The principal amount of a bond refers to the amount that a bondholder would receive at maturity, excluding coupons. In other words, this is the lump sum amount that would be paid when the bond matures or expires. This is also known as the face value.
The issue price of a bond should, in theory, equal a bond’s face value as this is the full amount of the loan. But, the price of a bond on the secondary market – after it’s been issued – can fluctuate substantially depending on factors like the borrowing rate. However, bond prices will always revert to its face value at the point of maturity.
Coupon dates refer to dates on which the bond issuer is required to pay the coupon. The bonds’ coupons are normally paid annually, semi-annually, quarterly or monthly.
The coupon rate of a bond refers to the percentage value of the bond’s coupon payments against the bond’s principal amount, calculated annually. For instance, if the principal (or face value) of a bond is $1000, and it pays an annual coupon of $50, its coupon rate will be calculated to be 5% per annum. Coupon rates are usually annualized, so two payments of $25 will return a coupon rate of 5%.
A par value bond is traded at face value. If the price is below par, it is trading at a discount, and if the price is above par, it is trading at a premium.
You may hear investors say that government bonds are a risk-free investment. There is a theory that the principal will always be paid when the bond matures because the government can print more and more money to pay off the debt.
In reality, the picture is more complicated. First, governments cannot always create more capital without consequences – and sometimes, these consequences can outweigh the risks of a default. This, however, is a remote possibility. The U.S. government has only defaulted on payments once, in 1979 due to a technical glitch. Meanwhile, countries like Greece and Spain have defaulted at least once.
However, credit risk aside, government bonds have some other potential pitfalls to watch out for including interest rates, inflation and currency risk.
Interest rate risk is the potential for a bond’s value to decline due to rising interest rates. This is because high interest rates affect the opportunity cost of holding bonds.
Inflation risk is the possibility that a bond’s value will decline due to rising inflation. If inflation exceeds the bond’s coupon, you lose real money on your investment. Index-linked bonds have less risk of inflation.
Currency risk exists only when buying government bonds paid in a currency other than the reference currency. In this case, exchange rate fluctuations may reduce the value of your investment.
Different countries that issue bonds use different terms. Hence, it can be quite confusing for new bond investors.
In the United States, government bonds are called Treasuries. According to maturity, he falls into three broad categories.
Treasury bills (T-bills) expire in less than a year
US Treasury Notes (T-Notes) expire in 1 to 10 years
Treasury bonds (T-bonds) expire in 10+ years
Other governments bonds with unique names include:
Gilts, which are bonds issued by the United Kingdom
Bunds, which are bonds issued by Germany
There are also government bonds that do not have fixed coupons. Instead, interest payments fluctuate according to the rate of inflation. In the US, these are linked to the Consumer Price Index (CPI) and are called Treasury Inflation-Protected Securities (TIPS). In the UK they are called index-linked gilts and coupons move with the UK Retail Price Index (RPI).
Similar to all the other financial assets, the price of government bonds is also influenced by supply and demand. The supply of government bonds is controlled by each government, and new bonds can be issued as needed. The demand for bonds is normally influenced by whether the bond looks like an attractive investment.
Interest rates significantly impact the demand for bonds directly. If the interest rate is lower than the bond’s coupon rate, demand for that bond may increase. On the other hand, if interest rates rise above the bond’s coupon, demand may decrease.
Newly issued government bonds are always valued taking into account current interest rates. This means that they are usually traded at par or near par. When the bond reaches maturity, it’s just a repayment of the original loan. That is, the bond returns to its par value as it nears maturity.
The number of interest payments remaining before a bond matures also affects its price.
Government bonds are generally considered low-risk investments, because governments tend to be less likely to default on loan payments. However, defaults can still occur and riskier bonds typically trade at lower prices than less risky bonds with similar interest rates.
A country’s risk of default can be assessed primarily based on its ratings from the three most important rating agencies: Standard & Poor’s, Moody’s and Fitch Ratings.
High inflation is usually bad news for bondholders. There are two main reasons for this.
You can trade the Treasury futures market to speculate on interest rates and hedge against interest rate risk and inflation. We can do this by taking positions in CFDs.
With CFDs, you deposit a small amount of money (called margin) to open a larger position, but profits and losses are calculated on the size of the entire position, not on the small amount of margin.
It is important to note that leveraged financial products are complex and carry inherent risks. Leverage allows you to earn more with less capital if you accurately predict market movements, but you can also lose more if the market moves against you. Therefore, unlike outright ownership of a bond, losses are not limited to the underlying value of the bond.
In conclusion, government bonds are widely traded by investors or traders to predict the movement of interest rates. Many investors or traders also trade government bonds to protect themselves against rising interest rates and high inflation.
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