May 29, 2023
Since they’re considered a low-risk investment, government bonds are an attractive option for traders to diversify their portfolios by taking a position on this government-backed debt instrument.
If you’ve ever wondered about buying government bonds, how they can be traded or what the risks associated with them are, here’s our in-depth guide on everything you need to know about them.
What are government bonds?
Government bonds, like all bonds, are straightforward debt instruments. They are used by federal, state, municipal and local governments to raise capital in the form of a loan from an individual, known as the bondholder. The government issues a bond for the amount of the loan, which details both the maturation point of the loan — that is, when the full repayment of the original amount is due — as well as interest repayments that will take place. These interest rates are known as coupon rates, and the bond will detail how much these repayments will be and when they are due — on a monthly, quarterly, semi-annual or annual basis.
Both the US and UK governments offer bonds. In the US, they are known as Treasuries, and in the UK, they are known as gilts. Both governments offer a debt instrument that works in very similar ways.
How do government bonds work?
When a government issues a bond for a fixed amount, you loan them this amount for an agreed period of time. The amount is known as the principal or face value of the bond. During the agreed period, the government will give you a return on your loan by making scheduled interest payments known as coupons. This means that government bonds are a fixed-income asset.
When the bond reaches maturation and expires, the government will return the full principal amount back to you. The maturation period could be anywhere from a year to 30 years, and the maturation length of a bond can affect its value on secondary markets.
Bonds can be traded and sold before their maturation date to other investors at an amount that’s known as the issue price or bond price. In theory, a bond’s price is equal to its face value, and this is usually true at the point of issue and right before a government bond expires. However, various factors can cause the issue price of a bond to fluctuate dramatically during its active period.
The interest payments on a government bond are its coupon rates, and the agreed dates on which these payments are made are called coupon dates. The coupon rate is always calculated as a percentage of the bond’s principal — for example, 5% per annum.
Types of government bonds
Although there might be a lot of specific, seemingly complex terminology around trading and investing in government bonds, they are actually simple. Once you’ve mastered the terminology associated with government bonds, you can learn the distinctions between the different types of bonds offered by a country’s government.
- In the UK — Bonds issued by the UK government are known as gilts, and they all contain their maturation date in the title. So, a bond that will expire in three years is simply called a three-year gilt.
- In the US — The US has three distinct types of government bonds they will issue: Treasury bills, Treasury notes and Treasury Bonds. They are often shortened to simply T-bills, T-notes and T-bonds. T-bills expire within one year, T-notes expire between one and 10 years and T-bonds expire in more than 10 years, often within 30 years.
Other countries’ governments also issue bonds that have their own distinct types and naming conventions. If you’re interested in government bonds issued by another country, it’s worth taking the time to understand how their government bonds are structured before you make an investment.
Index-linked bonds
As well as traditional fixed-income asset bonds, it’s possible to buy bonds that don’t have a fixed coupon price and instead offer repayments that are calculated in line with inflation rates.
- In the UK — Index-linked bonds issued by the UK government are known as index-linked gilts.
- In the US — The US government calls index-linked bonds Treasury Inflation-Protected Securities or TIPS for short.
Buying government bonds
It’s possible to become involved in both trading and investing in government bonds. The first way to invest is to buy bonds directly from the government when they are being newly issued, in an auction. Usually, it’s large financial institutions and banks that will purchase bonds in these auctions. It’s also common for these institutions to onsell government bonds to other banks, pension and retirement funds, and individual investors.
Buying government bonds is also possible on the stock exchange, where many types of bonds are listed. However, the most common way of investing in government bonds is through OTCs (over-the-counter products) that are traded with institutional broker-dealers.
One such way of doing this is with speculation on the bond futures market through bond CFDs or contracts for difference. Because government bond issue prices are closely related to interest rates and inflation, the choice to trade bonds CFDs can be a good way to hedge against risks associated with these factors.
To take a position with bond CFDs, a trader puts down a deposit known as a margin in order to open a larger position. This is a method known as leveraged trading, and it’s how all CFD trading works. All leverage financial products are inherently risky because they are so complex, which means they require a careful approach. While your profits will be maximised by successfully speculating on a bond CFD, the inverse is also true. Your losses will be calculated on the total asset value, not the percentage margin you used as capital for a deposit. Accordingly, your losses could outstrip your initial investment amount significantly.
To help you manage this increased risk, it’s important to understand what can affect the price of government bonds.
What moves the prices of government bonds?
Government bonds can be affected by several factors and are often a reflection of larger trends within a country’s economy.
- Supply and demand — Just like any asset, supply and demand will affect the price of government bonds on open markets. The government controls a large portion of this supply, as it chooses when it will offer bonds at auction.
Governments may choose to curb this supply in order to better balance out demand, which is less when government bonds are seen as less attractive investments.
- Interest rates — One of the big reasons government bonds may lose their attractiveness is because interest rates are up. If interest rates are higher than the coupon rate for a bond, it’s likely investors will look for a more rewarding asset. However, if interest rates drop below the coupon rate, bond demand can go up.
- The distance to bond maturity — When a government bond is first issued, it’s simply a reflection of current interest rates, and so its price is at or close to a 1:1 ratio with its principal. The closer a bond is to its maturation, the more aligned its issue price will be with its principal or face value. This is because the bond’s price adjusts to reflect that it is now essentially just a payout of the principal.
In between these two points though, the price may fluctuate especially when taking into account the amount of interest rate payments it has to pay out.
- Credit ratings — Third-party ratings agencies determine the investment grade of all corporate bonds and government bonds, giving them a rating from AAA downwards. This rating aims to assess risk, and while the default rate for established economies’ government bonds is low, there’s still an element of risk involved. If bonds have a similar interest rate, the lower-rated one will likely trade at a lower price.
- Inflation — Increased inflation rates are usually not a good sign for bondholders — they signal that a bond’s fixed coupon price may become a lot less attractive, and they often occur in line with interest rate increases.
Because national reserve banks will often use an interest rate rise as a tool for curbing inflation, a rise in the inflation rate could see your government bond coupon rate drop below current interest rates, therefore making trading bonds less attractive.
Why do people trade government bonds?
Government bonds, despite having some associated risks, represent a strong, stable way to diversify your portfolio. They can help traders hedge against interest rate fluctuations, and they can also offer regular income via coupon payments.
If you’re ready to start trading government bonds, the team at VT Markets is here to help. Download the powerful MT4 or MT5 trading platform today and create an account to begin building up your portfolio.
FAQs
How risky are government bonds?
All investments and trades are associated with some level of risk. However, when it comes to government bonds from stable countries with powerful economies like the US and the UK, these assets are considered relatively low risk and a good way of calming volatility within your portfolio.
Government bonds are technically classed as ‘unsecured’ by the US treasury — i.e. government assets are not offered as collateral to guarantee the principal of the bond. However, bonds have been a historically very safe asset, with a low risk of the government defaulting and not returning the full face value of the bond.
Government bonds do carry with them some credit risk. That is, the risk that the issuer — in this case the federal, local or municipal government — will not be able to make their repayments in full and on time. Credit agency ratings for bonds help traders to assess the level of this risk. AAA-rated loans are considered to be the safest and the most likely to be repaid in full. At the other end of the spectrum, a BB+ loan may offer higher rewards, because it also carries a higher risk of defaulting.
If a national economy faces very high interest rate hikes for prolonged periods, this will also affect the value of a government bond and could make it harder to offload the asset, as investors seek more attractive options within the inflated interest rate market.
What are the ways to trade government bonds?
When it comes to trading, government bonds can be bought and sold directly, or traders can get exposure to this low-risk asset via the secondary market through the use of over-the-counter products (OTCs) like bond CFDs. To trade bond CFDs, traders speculate about the movement of a bond’s issue price on the market, profiting from both price spikes and drops.
By trading government bonds in this way, traders are essentially using an instrument that allows them to speculate on a country’s interest rates. The value of a government-issued bond is inversely related to interest rates — when rates rise, the price of bonds fall. To successfully trade bond CFDs on the secondary market, you’ll need to correctly predict the rise or fall of interest rates and back the price of government bonds to do the opposite.
It’s important to remember that managing CFDs requires a lot of research on and familiarity with these complex financial instruments. Before deciding if trading government bond CFDs is right for you, it’s recommended you thoroughly understand how to trade CFDs and the various CFD trading strategies you can practise in order to maximise your chances of making a profit.
