A government bond is issued by the government, but why do they do this? A big difference between stocks and government bonds is that you are not a shareholder if you buy a government bond. There are however some risks associated to buying government bonds. But what are the risks of government bonds? To minimize the risk, you can use the bond rating.
A government bond is issued by the government. Because the government sometimes has to spend a lot of money, their cash reserves becomes empty, and shortages may be created. The government then has to borrow. The government then starts issuing bonds. A government bond is an obligation of the state with a fixed interest rate and a maturity of usually ten years. Shorter durations are also possible, as well as longer durations:
- 5 years or less: short term
- 5-12 years: medium term
- 12 or more: long term
If a person buys a government bond, nothing happens with the total money supply. The government first paid its people after which it created a deficit, and the people now return money to the government. The amount of money with the people remains the same. If government bonds are purchased by the bank, the situation is different. Payments to individuals are not compensated by the individuals themselves. If the government finances its spending with money it borrows from banks, it does lead to an increase in the money supply.
Difference between government bonds and shares
A government bond serves to cover the state’s debts. With a share is you become shareholder of the company, which is not the case with a government bond. To the government, the buyers of government bonds are like a kind of bank. You give money to the government, which you will get back later with interest, preferably.
Buying government bonds
The higher the interest rate on a government bond, the higher the risks. In some countries, including Germany and the Netherlands, the interest rate can also be negative.
There are three different types of risks of government bonds.
You have to consider the price. If you are going to sell your bonds prematurely, the amount of money you get for it depends on the market price. A government bond usually has a maturity of ten years. So if you wanted to sell your government bonds prematurely, you have to take into account the market value of the government bond.
A government bond is still in state hands. At the maturity date, the state will have to buy back the bond. You should consider, however, that a state can go bankrupt, especially if it has financial problems. If the state goes bankrupt, you have little chance to get your money back.
A less significant risk is the currency risk. With currency risk there is a chance that for example the US dollar depreciates in value. If you buy a government bond in another currency, there is a chance that you get less for your money, for example, due to a depreciation of the US dollar.
The bond rating is a rating which indicates the solvency of the issuer of the government bond. To make sure that your bond is not too risky, you can consult these bond ratings. Due to the credit crisis at the beginning of the 21st century, the creditworthiness in for example Greece was very low. Because the likelihood of getting your money back was low, people were no longer investing in Greek government bonds, causing the economy to basically collapse. People were also not investing in government bonds due to the higher interest rates, which was used to help Greece. The risk is greater with a higher interest rate, and almost no one was willing to buy bonds anymore.