What are Government Bonds: Advantages and Disadvantages in comparison

Two aspects determine the discussion about the financial conduct of the state: Faith and trust in its financial omnipotence on the one hand. The hope for sound budgeting on the other. There is often a financial gap between these claims, also known as the budget deficit in the language of budget politicians. Last year, the Finance Minister caused a stir when he was able to present a balanced budget for the first time in over 40 years. Before that, however, the state regularly took on debts to cover its financial needs, piling up a considerable mountain of debt. However, when a state needs fresh money, it does not go to the nearest bank like a private individual and take out a loan, which it pays off little by little. The debts of a state are in so-called government bonds. Government bonds are nothing more than promissory notes, which the state issues in exchange for corresponding amounts of money. On the other hand, they are creditors who purchase the promissory notes and thus make their capital available to the state. In principle, this process is nothing other than one actor, namely the state, borrowing a certain amount from a second actor, the private investor. In addition, a number of rules are agreed on regarding the conditions for this exchange. Of central importance are the duration and the amount of the agreed interest to be paid to the creditor for each year. Unlike private loans, for example, government bonds can also be freely traded on the bond markets. In other words, the creditor always has the possibility to sell his securities and thus get his money immediately, and not only when the term of a government bond allows it. This outlines the most important aspects of how a government bond works. However, there are also a number of other aspects to consider: How can the private investor benefit from this type of investment? Where can such securities be purchased? What are the differences to be considered and what is the risk involved in buying government bonds? These and other questions will be answered in the following sections.

Different forms of Government Bonds

Form government bonds are debt securities issued by the government, as was already clarified in the first section. But the topic is far from being exhausted. For government bonds, similar to shares or other financial products, there is also a broad selection and different offers. This starts with the question of who actually issues government bonds. In addition to the German state already mentioned, almost all other states in the world also regularly issue bonds to raise money on the capital market. On the other hand, the European Union, at least for the time being, is not yet entitled to issue its own bonds. In addition to the nation-states, however, it is also the subordinate administrative unit that can issue their own bonds. In Germany, these are the federal states, although they are no longer referred to as government bonds in the strict sense. State banks, such as the KfW, also issue their own bonds, which can certainly be equated with government bonds in terms of the level of security and also have a slight yield advantage over federal government bonds. The disadvantage, however, is that they are more difficult to sell on the free market. In other countries, too, lower levels of government are entitled to issue bonds. In the USA, federal states and also local authorities can issue so-called “municipal bonds”. However, these variants cannot be compared with the safe bonds at the state level in Germany. Furthermore, there are also different forms and variants with regard to the respective issuer, i.e. the specific issuer of the bonds. With regard to the Federal Government as a bond issuer, for example, this means that there is a choice of eight different types of German Government securities. Even within these investment options, there are again differences in terms of the term of the bonds. The most common form, and thus the classic among government bonds, is the German Government bond, which is available with a maturity of 10 or 30 years. In addition, there are so-called inflation-indexed German Government securities, Federal notes, Federal Treasury notes, or day-to-day bonds. Without going into the specifics of each individual product, government bonds and their issuance by the state always follow a fixed principle. Government bonds are offered on the capital market at regular intervals by the government. This is because old government bonds also expire regularly, i.e. funds must be repaid to creditors. In order to pay off these creditors, the government usually has to issue a new bond. There is therefore a relatively continuous need for financing. For a planned bond, a certain interest rate, the so-called interest coupon, is determined in advance. This is a fixed interest rate that has to be paid regularly to the owner of the bond. In determining this interest coupon, the issuer also bases its calculations on the so-called current yield, which reflects the current interest rate level. The current yield itself is calculated on the basis of the securities currently in circulation at the federal and state levels. Even if the interest coupon is fixed and remains unchanged during the term of the bond, the actual yield of a government bond can change and fluctuate. This is because the corresponding securities can be freely traded on the capital market after the issue. This is usually also associated with a change in the price that has to be paid for a government bond. The interaction between the bond market price and the fixed interest coupon then results in a current market interest rate. So if a bond worth 100 euros is issued with an interest coupon of one percent, the interest rate is one percent. If the price of a bond falls by two euros after issue, the bond is bought on the stock exchange for 98 euros, the yield automatically increases from 1 to 1.02 percent, as the interest rate is still based on the nominal value, i.e. the issue price. However, the fluctuation margin of corresponding securities is rather small over the term of the bond. In many cases, the price falls after the issue and usually approaches its nominal value again as the end of the term approaches. The investor can also assume that the nominal amount will be paid out again at the end of the term, in our case 100 euros. Recently, however, it has also happened time and again that the market price of German government bonds, in particular, has exceeded the nominal value, thus depressing interest rates. If the market price of a bond increases by about two euros, the yield falls to 0.98 percent.

In addition to the German state, almost all other states also finance themselves, as already mentioned, by issuing government bonds. There are certainly differences. In recent years, the media have been particularly aware of the cases of bonds issued by bankrupt states such as Argentina. But even in Europe, the government bonds of crisis-ridden states such as Greece or Spain were at times a constant topic in the media. Contrary to what many people suspect, there is also a massive default risk with government bonds that are actually considered safe. In addition to a genuine government bankruptcy, a so-called debt cut, also known in financial circles as a “haircut”, can ensure that the investor is no longer paid anything or only part of the original value of the bond when it matures. This means that there is also the possibility of a total loss for government bonds. The imminent insolvency of an issuer has a direct impact on the price level of a bond. In the case of Greek bonds, prices at times fell to such low levels that yields of 20 percent and more were possible. In the opposite case, however, it is quite possible that actual yields will slip into negative territory. This is the case when investors push so hard into government securities that, due to high demand, bonds with a coupon of zero or even lower can be issued and find buyers.

Particularly with regard to government bonds from economically insecure issuers, these securities can also develop into outright speculative objects. In the case of the Greek bailout, investors in government bonds in the summer of 2015 could bet on whether or not negotiations on a further rescue package would fail. Failure would probably have meant at least a partial default by Greece and would have brought investors in government bonds enormous discounts. However, this should not hide the fact that government bonds are basically among the most solid and secure investment opportunities, at least if they come from issuers with high or the highest credit ratings. These include Germany, the Scandinavian countries, Switzerland, Luxembourg, Canada, and the USA.

In principle, government bonds are also categorized according to their maturity. A distinction is made between short, medium, and long-term investments. Maturities ranging from one year to 30 years and even beyond are possible. As a rule, long-term bonds offer higher interest rates than short ones.

For whom are Government Bonds suitable as an investment and what should be considered

Government bonds, unlike shares, are generally considered to be investment opportunities with very low risk. At least if they are issued by countries with a high credit rating. This form of financial investment is therefore generally suitable for investors with a high need for security. However, especially in the case of government bonds issued by the federal government, the yields have recently been so low that the money could also be stored in the bank’s overnight or fixed-term deposit account with similar security. The risk of default by the Federal Government can currently be regarded as very low. In the case of bank deposits, the money is protected by the joint German deposit guarantee up to an amount of 100,000 euros. This sum is one reason why larger investors resort to government bonds, even if the returns are more than modest or even negative. For amounts above 100,000 euros, the protection of deposits with banks is no longer fully protected in the event of the institution’s insolvency, so the security argument tends to favor government bonds for higher amounts. For private investors who are not in the position to worry about investing more than 100,000 euros, there are few reasons to invest in this form, at least in a situation of low yields on government bonds. Corporate bonds from large Dax companies offer significantly higher yields of three to five percent with reasonable security. However, government bonds also offer better returns for the investor if the investor looks a little further afield. Both German federal states and states in other European countries offer quite acceptable yields. These include countries such as France and Spain, which offer interest coupons of two to three percent. In these countries, bonds are issued in euros, which means that investors do not have to take currency risk into account.

The situation is different for bonds issued by countries outside the European Union. Since government bonds are usually issued in the corresponding national currency, both the regular yield and the value after repayment are directly related to the development of the national currency. However, many countries also issue bonds in foreign currencies, usually in US dollars, which still offers a certain degree of security compared with completely unpredictable currencies. However, significant fluctuations in value over the years cannot be ruled out or are more likely to occur in the relationship between the US dollar and the euro. On the other hand, this means that an investment in a government bond outside of Europe also offers the chance of substantial currency gains, which may well be in the 20 to 30 percent range. If, as is currently expected, a long-term depreciation of the euro against the US dollar is expected, an investment in a US government bond may well prove to be a promising investment. With a current interest rate level of just under 3 percent for the 30-year bond, these securities are currently much more attractive than German government bonds. In the event of a long-term appreciation of the US dollar against the euro, the yield and the value of the share certificate itself would also rise against the euro and provide the owner with an additional profit. If, on the other hand, the hopes of a strengthening of the US dollar are not fulfilled, corresponding losses are possible.

From a purely technical point of view, the investor needs no more than a securities account at a bank to buy government bonds. When buying government bonds, investors must also pay attention to the denomination of the bonds. In most cases, government bonds are not issued for less than EUR 1,000 per note. However, prices that are significantly higher are not uncommon. For smaller amounts, this option is therefore absolutely unsuitable. Alternatively, bond funds can also be invested.

Conclusion: Government Bonds both as a safe bank and as an object of speculation

Euro government bonds can in principle still be regarded as the safe bank in the custody account – the default risk for German government bonds can be neglected and equated with that of German banks, which are protected by the deposit guarantee scheme. In principle, investors do not need to fear a price risk either, as their assets will be paid out in full at maturity. In times of low yields, however, it should be considered whether the money in the call money account is not better off as long as the interest rate level is identical.

Apart from German government bonds, however, there is also a choice of bonds with significantly more attractive yields. Such bonds also offer a low default risk. But even investors who are open to speculative investment opportunities are not completely wrong when it comes to bonds: in the case of bonds issued in foreign currencies, one can speculate on the development of exchange rates. Bonds that are acutely threatened by default can also be regarded as highly speculative, as was recently the case with Greece. For the security-conscious investor, however, such investment opportunities are probably not a realistic option.

Leave a Reply

Your email address will not be published. Required fields are marked *