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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Government Bond

What it is:

A government bond is debt issued by the government.

How it works (Example):

The Treasury Department usually issues government bonds, typically through an auction process. Institutional investors make up most of the market for government bonds, but individual investors can easily purchase and trade them as well. Investors interested in purchasing Treasuries can do so directly from the Treasury Department's TreasuryDirect website or through banks and brokers.

For example, savings bonds are also sold by the U.S. Treasury. Savings bonds come in electronic form and can be purchased from most financial institutions or via the U.S. Treasury's TreasuryDirect website. When a savings bond matures, the investor receives the face value of the bond plus accrued interest. Savings bonds are not redeemable for the first 12 months they’re outstanding, and investors who redeem within the first five years forfeit the last three months of interest as a penalty.

Treasury notes (T-Notes) are intermediate-term bonds issued by the U.S. Treasury. They mature in two, three, five or 10 years. T-Notes make semiannual interest payments at fixed coupon rates. T-Notes issued before 1984 are callable, meaning that the Treasury can repurchase the notes under certain circumstances. T-Notes usually have $1,000 face values, although those with two- or three-year maturities have $5,000 face values.

Treasury bonds ("T-Bonds") are long-term bonds issued by the U.S. Treasury. They mature in 10 to 30 years. T-Bonds make semiannual interest payments and have $1,000 face values. They help fund shortfalls in the federal budget, regulate the nation's money supply, and execute U.S. monetary policy. 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).

Why it Matters:

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 offer inflation protection, and have little or no capital gains opportunity.

Many investors hold government bonds through mutual funds. The fund-management fees do cut into returns, but the funds offer diversification 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.)

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