This is part three of a series on the bond market. Part three is specifically about government bonds. Click here for part one. Click here for part two.
As discussed briefly, government bonds form the baseline for the rest of the bond market, so understanding how they work is an essential part of understanding the bond market as a whole. We will focus on government, municipal and agency bonds in depth in this article.
Government or sovereign bonds are issued by federal governments to support their spending. These bonds represent a promise to make interest payments on a regular schedule and then pay back the face value on the date they mature. Government bonds are issued in the currency of the country whose government issues them.
As an example to explain how government bonds work, let’s say an investor sinks $50,000 into 10-year Treasury bonds with a 5% annual coupon. It means the federal U.S. government will pay 5% of the $50,000 every year as interest and then pay the $50,000 back 10 years later when the bond matures.
Creditworthiness
As with other types of bonds, one of the first factors that determines the terms by which a bond can be issued is the government’s creditworthiness. In the U.S., the Treasury note represents the basis for the entire bond market because the federal government is considered as having no credit risk.
In other countries, bonds issued by their government in their own currency are considered as having no credit risk because in a worst-case scenario, the government can just print more money to pay off the bond. Of course, that would work only in theory in extreme cases like Venezuela, where the currency is essentially worthless due to hyperinflation caused by the government repeatedly printing money.
International governments have different credit ratings, depending on what’s happening in their budget or economy. Credit rating agencies will provide their own ratings for each government’s bonds, although investors will decide what they feel the bonds are worth or what they are willing to pay for them.
Most governments don’t default on the bonds they issue, but that doesn’t mean it never happens. When a government does default on its bonds, it’s because officials decided they would rather default on debt in their own currency by not printing more money.
The importance of the 10-year Treasury Note
In the U.S., there are several different types of bonds issued by the federal government. Savings bonds are one of the safest investments available. Treasury Notes mature in two, three, five or 10 years and provide fixed coupon payments every six months. Their face value is $1,000. Treasury Notes differ from Treasury Bonds, which mature in 20 to 30 years. Like the Treasury Note, Treasury Bonds offer coupon payments every six months.
The 10-year Treasury Note is especially important because it’s arguably the most popular debt instrument of all, even in other countries around the globe. Treasuries are sold at auction, and the more popular they are, the more investors will pay for them. However, a higher price means the yield is lower because the return on the investment will be less. During times of economic turmoil, some investors are comfortable paying more for safe investments like the 10-year Treasury because they know their money will not only be safe but also provide a steady source of fixed income during the life of the note. On the other hand, when the economy is humming along and other investments are outperforming Treasuries, investors won’t pay as much for them. Thus, the price falls below the face value, although the yield is higher because the note was bought at a discount.
The 10-year Treasury’s importance stretches beyond its importance as an investment. Ten-year Treasuries also impact interest rates on 10- and 15-year loans. The note also serves as a benchmark for other interest rates, excluding loans that follow the Federal Funds Rate, like the adjustable-rate mortgage. However, the Federal Reserve even looks at the yield of the 10-year Treasury when deciding whether or not to change the Federal Funds Rate. The reason is because the yield acts as a sort of measuring stick for investor confidence in the economy.
Agency bonds and municipal bonds
Another type of government bond is an agency bond, which is issued by an agency that’s sponsored by the federal government in some way. One difference between agency bonds and other federal bonds is that although they are backed by the U.S. government, they are not guaranteed, so they carry more risk. Fannie Mae and Freddie Mac are two government-sponsored agencies that can issue agency bonds.
Municipal bonds are issued by local governments rather than federal ones. Cities or states issue municipal bonds to fund infrastructure like roads and bridges or public projects like schools. Other than cities and states, counties, redevelopment agencies, public utilities and other public entities may also issue municipal bonds.
Like bonds issued by the federal government, municipal bonds can be issued in shorter or longer terms. Short-term issues are often referred to as notes, and their maturities are usually one year or less. Long-term issues mature in more than a year and are commonly referred to as bonds.
There are two different types of municipal bonds. General obligation bonds are secured by both the credit and faith of the government that issued them. They are usually paid for from taxes and are often approved by voters. Revenue bonds are paid for from tolls or rents on the facility that was built using their proceeds. For example, a state may wish to build a new highway or bridge, but to pay for it, the state government may sell bonds. The state may install tollbooths on the road or bridge to collect funds to pay for the bonds.
Unlike federal governments, municipal bonds do carry some credit risk. The risk will vary greatly according to the governing agency that issues them. Cities which are on the verge of bankruptcy obviously represent a much greater credit risk than those with a balanced budget and extra tax revenues. A rating agency like Moody’s, Standard & Poor’s or Fitch will assign a rating to each bond according to the risk inherent in buying them. General obligation bonds are usually considered to be the safest kind, but they have lower interest rates.
The next article in this series will focus on the many different types of corporate bonds.