What is a Government Bond
A government bond is a debt security issued by a government to support government spending. Federal government bonds in the United States include savings bonds, Treasury bonds and Treasury inflation-protected securities (TIPS). Before investing in government bonds, investors need to assess several risks associated with the country, such as country risk, political risk, inflation risk and interest rate risk, although the government usually has low credit risk.
BREAKING DOWN Government Bond
Because most government bonds are backed by the credit of the U.S. government, default is unlikely and government bonds are considered essentially risk-free. Thus, government bonds create a benchmark against which riskier securities may be compared.
Pros and Cons of Government Bonds
Government bonds are considered risk-free and are traded in highly liquid markets. Certain government bonds restrict the dollar amount that may be purchased per calendar year. On the downside, government bonds return a typically low rate of return. Only select bonds offer protection against inflation, which may outpace the bond's interest rate. Also, government bonds have minimal capital gain opportunities. Government bond prices are tied to interest rates, so government bonds with fixed rates will incur interest rate risk as fluctuations in interest rates may cause a decline in value of the bond.
Control of the Money Supply
Government bonds assist fund deficits in the federal budget and control the nation's money supply. When the government repurchases its own bonds, the money supply increases as sellers receive funds to utilize in the market. Eventually, when funds are deposited into a bank, financial institutions utilize the money multiplier to expand the money supply. Alternatively, the government can also sell bonds that reduce the money supply as buyers are forgoing the ability to hold money now for future economic benefit. The government receives cash for its bonds and may proceed in retiring the cash to restrict the money supply if it chooses.
Types of Treasury Savings Bonds
The U.S. Treasury offers two types of savings bonds. The first is called a Series EE bond. Sold at half its face value, all Series EE bonds receive a fixed and stated rate of interest. However, if the bond is held for 20 years, the value of the bond will double and result in an effective pre-tax interest rate of 3.53%.
Series I bonds receive interest based on two figures. The first relates to a fixed rate of interest established periodically. The second is a rate tied to an inflation rate calculated on a biannual basis.