A Guide to Buying Securities: Focusing on Government Bonds

What is a government bond?

Government bonds are debt instruments of a sovereign state issued by the government. These instruments are sold to the public, corporations and other financial institutions to fund public spending, including day-to-day government operations, infrastructure (bridges), military projects, and at times to pay down government debt.

When a government bond is sold, investors effectively lend money to the government in exchange for regular interest payments and the eventual return of the principal amount at maturity. When a government bond matures, the investor receives back the original principal amount (face value) that they initially invested, along with any accrued interest payments (coupons).

Types of government securities

There are several government securities which include Treasury Bonds, Treasury Notes, Treasury Bills, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes.

• Treasury Bonds are long-term debt securities with maturities over 10 years.
• Treasury Notes have maturities ranging from 2 to 10 years.
• Treasury Bills are short-term securities issued with maturities under one year.
• Treasury Inflation-Protected Securities adjust their principal based on the Consumer Price Index (CPI), which safeguards them against inflation.
• Floating Rate Notes are bonds where the interest rate (coupon) adjusts every 3 to 6 months, based on a reference rate (like LIBOR or JIBAR) plus a fixed spread, which offers protection against rising interest rates.

What is an interest rate?

Interest rates reflect the cost of borrowing money and forms a critical part of the economy. At a basic level when a country's central bank lends to other banks it does so at what is known as a benchmark interest rate - sometimes called a base rate or policy rate. When the economy is growing too quickly or inflation is too high, the central bank may increase the interest rates.

This prompts retail banks to raise the rates at which they lend, which pushes up the cost of borrowing. Banks can also raise their deposit rates which makes the savings rate a lot more attractive. On the other hand, when the economy slows down the central bank may reduce the base rate. This makes it less attractive to save and may incentivise people to borrow and spend more money.

How do interest rates affect bonds?

Bond prices tend to have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.

This happens because the price of a bond reflects the value of the income it delivers through its coupon (interest) payments. When interest rates on government bonds fall, demand for older or longer-dated bonds rises because they offer higher interest rates and become more valuable to investors. Due to this strong demand any investor who holds these bonds can charge a premium to sell them in the secondary market.

Alternatively, when interest rates rise, older bonds become less valuable because their coupon payments become lower than those of the new bonds offered in the market. When demand for these older bonds drops and the interest rates rise, they are considered by investors to be trading at a discount.

What is interest rate risk?

Interest rate risk describes the potential for investments to lose value due to the changes in interest rates and their effect on fixed-income investments like bonds.

What is a bond yield?

A bond yield is the return an investor earns from holding a bond, which includes the interest payments (coupon) and any capital gains or losses from the changes in the bond's price.

What is a bond yield curve?

A yield curve is a line that plots the yields or interest rates of bonds that have equal credit quality but different maturity dates. When the yield is analyzed, it provides insights into market expectations for future interest rates, economic growth, and inflation. Its shapes are either – normal, flat, or inverted – all of which offers clues about the economic outlook.

What is a normal yield curve?

A normal upward slopping yield curve occurs when short-term bond yields are lower than long-term bonds. It usually indicates a healthy economy with expectations of future economic growth and potential inflation, this leads investors to demand higher returns for longer-term investments. A normal yield curve might show a 2-year Treasury bond yielding 2%, while a 10-year Treasury bond yields 3%.

What is a flat yield curve?

A flat yield curve happens when short-term and long-term bond yields are roughly equal. When this happens, it signals a transition from economic expansion to a slowdown or vice versa. This phenomenon often occurs when central banks raise interest rates to curb rapid growth. A flat yield curve might show both 2-year and 10-year Treasury bonds yielding around 2.5%.

What is an inverted yield curve?

An inverted yield curve happens when short-term bond yields are higher than long-term bond yields. It is often considered to be a rare occurrence and widely seen as a sign of a potential recession or economic slowdown, as investors anticipate a lower future interest rate. An inverted yield curve might show a 2-year Treasury bond yielding 3.75%, while a 10-year Treasury bond yields 3.5%.

What are the tax implications of owning bonds?

Interest income that emanates from treasury bills, notes and bonds is subject to federal income tax but exempt from all state and local income taxes. While different taxation rules apply to different government, corporate and municipal bonds, it's important for investors to understand that income earned from interest payments (coupons) will attract income tax. While these are general rules, it is important to consult a tax professional before investing.

What is a government agency bond?

Government agency bonds are debt securities issued by entities like Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, which are government-sponsored enterprises or government corporations, offering investors a way to lend money to these agencies. Agency bonds are considered low risk because the trust placed in the federal government to honour its debts is similar to that of the government agencies. However, unlike Treasury notes, government agency bonds can offer higher interest rates, since they are not directly guaranteed by the government.

How to buy/sell bonds?

U.S. Treasury securities can be bought or sold directly through Treasury Direct or via brokerage accounts using Exchange Traded Funds and Mutual Funds. They are issued at regularly scheduled auctions where they can be easily bought and sold. In the United States there are several ways to gain access to government bonds, which includes buying them directly from the government.

• Treasury Direct
• Banks and financial institutions
• Brokerage firms

Opening an investment account

To open a Treasury Direct account, you'll need a Taxpayer Identification Number, US address, checking or savings account, email address, and a web browser that supports 128-bit encryption.

Brokerage account options

There are three types of brokerage accounts namely cash, margin and prime.

Cash brokerage account: You deposit your own funds to purchase bonds, and you can only buy bonds with the cash you have in the account.

Margin brokerage account: Allows you to borrow money from the brokerage to purchase bonds, using the bonds as collateral. Trading with margin increases risk and may not be suitable for all.

Prime brokerage account: A more complex account offering a suite of services, including margin lending, and is typically used by institutional investors or high-net-worth individuals.

Choosing an investment account

Choosing the right investment account is crucial to achieving your financial goals. There are several types of investment accounts to choose from, each with its own benefits and drawbacks.

Types of investment accounts

Some common types of investment accounts include:

• Brokerage accounts: These accounts allow you to buy and sell individual stocks, mutual funds, and exchange-traded funds (ETFs).
• Retirement accounts: These accounts, such as 401(k)s and IRAs, offer tax benefits for saving for retirement.
• Robo-advisor accounts: These accounts offer automated investment management and diversification.
• Mutual fund accounts: These accounts allow you to invest in a diversified portfolio of stocks, bonds, or other securities.
• Exchange-traded fund (ETF) accounts: These accounts allow you to invest in a diversified portfolio of stocks, bonds, or other securities that trade on an exchange like stocks.

When choosing an investment account, consider the following factors:

• Fees and commissions: Look for accounts with low or no fees and commissions.
• Investment options: Consider the types of investments offered, such as individual stocks, mutual funds, and ETFs.
• Risk tolerance: Choose an account that aligns with your risk tolerance and investment horizon.
• Minimums: Check the minimum investment requirements and balance requirements.
• Customer service: Consider the level of customer service and support offered.

By considering these factors, you can choose the right investment account to help you achieve your financial goals. Whether you are looking to invest in individual stocks, mutual funds, or exchange-traded funds, selecting the appropriate account will provide a solid foundation for your investment strategy.

What are the benefits of investing in government bonds?

There are several benefits to investing in government bonds, including capital preservation, portfolio diversification, tax benefits and a predictable income stream earned through regular interest payments.

Predictable income: Bonds provide a regular income stream in the form of interest payments (coupons), which can be valuable for investors seeking a steady income stream.

Capital preservation: Bonds offer an element of capital protection as the issuer is contractually obligated to repay the principal amount at maturity.

Diversification: Bonds can help diversify an investment portfolio, as they tend to have a low correlation to stocks, which can help reduce overall portfolio risk.

Tax benefits: In some cases, interest earned on municipal bonds may be exempt from federal income tax and, in some cases, state and local taxes as well.

Safety and security: Bonds are considered low risk investments because they have a low default risk due to the backing government.

What are the risks associated with government bonds and risk tolerance?

There are several risks associated with investing in government securities, including credit risk, market risk, interest rate risk and inflation risk.

Credit risk: The risk that a bond's issuer will go into default before a bond reaches maturity

Market risk: The risk that a bond's value will fluctuate with changing market conditions

Interest rate risk: The risk that a bond's price will fall with rising interest rates

Inflation risk: The risk that a bond's total return will not beat inflation

What are bond vigilantes?

Bond vigilantes are bond market participants who act as a form of market discipline, often selling bonds or refusing to buy new ones to protest or express disapproval of a government's fiscal or monetary policies, which can lead to increased borrowing costs.