Government Bond Definition Example Essays
Government bonds usually help fund shortfalls in the federal budget, regulate the nation's money supply and execute monetary policy. For example, like any bond issuer, the U.S. Treasury considers the market’s risk and return requirements in order to successfully and efficiently raise capital. This is why there are several types of Treasury securities (T-Bill, T-Notes, T-Bonds, STRIPS and TIPS, for example).
Most government bonds are backed by the full faith and credit of the U.S. government, meaning that default is extremely unlikely and would really only occur if the U.S. government could not print additional money to pay off its debt. For this reason, T-Notes, for example, are generally considered risk-free investments and benchmarks against which other investments are compared.
Rates on government bonds affect the entire economy. This is partially because the government’s sale or repurchase of their own bonds affects the money supply and influences interest rates. For example, when the Federal Reserve repurchases Treasuries, sellers deposit the proceeds at their local banks, which in turn lend to customers, who deposit their loan proceeds in their bank accounts, and so on. Thus, every dollar of Treasuries repurchased increases the money supply by several dollars. The supply of money for lending increases and the demand for borrowing increases, causing lending rates to fall.
Government bonds are usually simple, low-risk investments. The state and local tax exemption, as well as the federal exemption for tuition payment, make some bonds especially advantageous for investors in high tax brackets or those with children heading to college. Government bonds are very liquid. However, government bonds usually have a very low rate of return, rarely offerinflation protection, and have little or no capitalgains opportunity.
Many investors hold government bonds through mutual funds. The fund-management fees do cut into returns, but the fundsofferdiversification among all the types and maturities of bonds, which is hard for the individual investor to achieve without significantly more cash than mutual funds require.
Though government bonds carry little risk of default, they do carry interest-rate risk, meaning that when interest rates rise, bond prices fall, and vice versa. Fortunately, in periods of rising interest rates, T-Note prices tend to fall less than other bonds do. Thus, with their virtually guaranteed income stream, government bonds make excellent defensive plays in an uncertain market.
Inflation takes a bigger bite out of government bond returns than from riskier but higher-yielding bonds. Thus, changes in inflation expectations or the degree of uncertainty about inflation can really affect government bond prices. For example, if the consumer price index increases by 3% over the life of the T-Note, then 3% of the T-Note's return is eaten away, leaving a much lower "real" return.
Income from government bonds is federally taxable but generally exempt from most state and local taxes. This means that for some investors, particularly those who live in states with high taxes, Treasuries may return slightly more than taxable securities with higher coupons. For example, if a resident of California and a resident of Nevada each purchase a $10,000 T-Note with a 3% coupon, each will have received interest payments of ($10,000 x .03) = $300 in one year. If the California resident’s tax rate is 20%, he really only earns $240 from the T-Note ($300 x .80). However, the same T-Note has a higher return in the eyes of the Nevada resident, whose state tax rate is 0%, because he gets to keep the entire $300. (Keep in mind that Treasury income may be subject to Alternative Minimum Tax, so investors should seek tax advice before investing.)
Differences Between Stocks and Bonds
Investors are always told to diversify their portfolios between stocks and bonds, but what’s the difference between the two types of investments? Here, we look at the difference between stocks and bonds on the most fundamental level.
Stocks Are Ownership Stakes, Bonds are Debt
Stocks and bonds represent two different ways for an entity to raise money to fund or expand their operations. When a company issues stock, it is selling a piece of itself in exchange for cash.
When an entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.
Stocks are simply shares of individual companies. Here’s how it works: say a company has made it through its start-up phase and has become successful. The owners wish to expand, but they are unable to do so solely through the income they earn through their operations. As a result, they can turn to the financial markets for additional financing. One way to do this is to split the company up into “shares,” and then sell a portion of these shares on the open market in a process known as an “initial public offering,” or IPO. A person who buys Stock, is therefore buying an actual share of the company, which makes him or her a part owner – however small. This is why Stock is also referred to as “equity.”
Bonds, on the other hand, represent debt. A government, corporation, or other entity that needs to raise cash borrows money in the public market and subsequently pays interest on that loan to investors.
Each bond has a certain par value (say, $1000) and pays a coupon to investors. For instance, a $1000 bond with a 4% coupon would pay $20 to the investor twice a year ($40 annually) until it matures. Upon maturity, the investor is returned the full amount of his or her original principal except for the rare occasion when a bond defaults (i.e., the issuer is unable to make the payment).
The Difference Between Stocks and Bonds for Investors
Since each share of stock represents an ownership stake in a company – meaning the owner shares in the profits and losses of the company - someone who invests in the stock can benefit if the company performs very well and its value increases over time. At the same time, he or she runs the risk that the company could perform poorly and the stock could go down – or, in the worst-case scenario (bankruptcy) – disappear altogether.
Individual stocks and the overall stock market tend to be on the riskier end of the investment spectrum in terms of their volatility and the risk that the investor could lose money in the short term. However, they also tend to provide superior long-term returns. Stocks are therefore favored by those with a long-term investment horizon and a tolerance for short-term risk.
Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors for whom income is a priority. Also, bonds are less risky than stocks. While their prices fluctuate in the market – sometimes quite substantially in the case of higher-risk market segments - the vast majority of bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than there is with stocks.
Which Is Right for You?
Many people invest in both stocks and bonds in order to diversify. Deciding on the appropriate mix of stocks and bonds in your portfolio is a function of your time horizon, tolerance for risk, and investment objectives.