What risks are associated with government bonds?
Investing in bonds is considered among the best avenues of earning passive income. Bonds are debt instruments where an investor gives a sum of money to a government or corporate entity for a certain period (maturity period). During this tenure, an investor earns interest on the principal amount (coupon amount), thus making it a perfect passive income earning scheme.
There are many types of bonds available for investment; government bonds are one of them. This article elaborates in detail about government bonds and whether they are a safe investment option.
What is a Government Bond?
A national government issues a government bond with a promise to pay periodic interest and repay the face value on the maturity (or expiration) date. The purpose of a government bond is to finance government spending as an alternative to taxation. A government bond is one of the least risky types of investment.
Bonds are offered in terms ranging from 30 days to 30 years; most government bonds are long-term, but shorter-term bonds are also available. The characteristics of a government bond can vary depending on the issuing country and also according to the specific type of bond. However, certain features are typical.
A government bond will often have a fixed coupon and maturity date. The coupon is the interest rate paid to investors at regular intervals (typically annually) until the bond's maturity. Then, the principal amount or face value is repaid to investors.
What are the main types of government bonds?
The main types of government bonds are:
- Treasury bond
- Treasury bill (T-bill)
- Municipal bond
- Sovereign bonds and supranational bonds
How safe are Investments in Bonds? Are they risk-free?
When you purchase a government bond, you loan money to the government. The term of your loan is known as the maturity date. At this date, The government will repay your investment, and you will have earned interest along the way. This means that government bonds are an investment and, as such, are not risk-free investments.
Although not risk-free, government bonds’ risks tend to be less than equity investments because they're issued by national governments instead of corporations or stocks. Government bonds are considered relatively low-risk compared to other types of debt securities but should still make up only a tiny percentage of your portfolio.
How is government bonds risk measured?
Here are a few ways in which you can measure a bond’s risk:
Credit Risk: The risk that a country will default on its debt. This is typically not an issue with countries like the US, Canada, or the UK, but it can be for countries like Greece and Venezuela.
Liquidity Risk: Can you sell your bond in case of an emergency (i.e. you need cash) without losing value? There were very few buyers of Greek sovereign bonds during the global financial crisis. Thus, their prices dropped gradually.
Inflation Risk: Your returns could be wiped out by inflation, especially if you're holding a bond to maturity where your interest rate is fixed and doesn't adjust for inflation throughout the life of your bond. You can't sustain yourself on a 4% coupon if the inflation is 8%.
Interest Rate Risk: Interest rates move up and down over time, and when they do, so does the value of bonds. Bonds that pay a lower rate than your peer group may go up in value as rates decline (e.g., when investors are worried about economic slowdowns), but as rates start to rise again, those same bonds may go down in value as investors realize they're not getting paid enough interest relative to other results offered elsewhere in the market place.
Risk Management in Bonds
Each of the risks is managed in its own way, through the evaluation of both qualitative and quantitative parameters:
Credit risk: Check for the credit rating of the issuer. AAA-rated bonds are the best, while anything below BBB- is bad.
Liquidity risk: If you're planning not to hold the bond until maturity, prefer investing in bonds with more buyers, eg. US or Chinese sovereign bonds.
Inflation risk: If the coupon on your country's sovereign bond does not meet the inflation numbers, try diversifying in international markets. Developing markets often give higher coupons since they're hungry for capital.
Interest rate risk: You must decide whether the potential gains from coupons outweigh the opportunity loss before investing in a particular bond or portfolio of bonds.