Government bonds are debt instruments of a state or state institutions with which they can obtain foreign money as a loan. They are part of safe investments, but in times of crisis the bond markets are also extremely volatile. We provide important information on government bonds and explain which alternatives investors have.
- Government bonds are used to finance government spending.
- Government bonds pay a fixed interest rate to the investor annually.
- They are traded on the stock exchange and are subject to price fluctuations.
- The interest rate and price of a bond depend on the credit rating of the country that issues it.
What are government bonds?
Short for GB by abbreviationfinder, government bonds are listed fixed-income securities . The interest rate is usually fixed over the entire term and is paid once a year on the interest date. It depends on the creditworthiness of the respective country and reflects the economic condition of a nation. The creditworthiness, in turn, is rated by rating agencies such as Fitch or Moody’s. Since a government bond is a loan , collateral is required. With a government bond, the collateral is rather abstract, as the state has to pay for the interest payment and the repayment. The rating of the agencies shows how high they assess the risk of a payment default, as investors have already had to experience with Argentina.
The grading is done using letter codes. The agencies give the top grade “AAA” (“Triple-A”). The gradation goes down through AA, A, BBB and so on up to D. The letters can also be combined with plus and minus for finer gradations. The area known as junk begins with the BB + grade. Each rating agency has its own grading rules. These ratings can give investors an indication of how vulnerable a government bond is.
How can you buy government bonds?
Investors can buy government bonds every trading day. The prerequisite for this is a securities account with a bank, savings bank or broker .
Reduce costs and optimize returns
For the purchase of a government bond, in addition to the market value, the brokerage fee for the bank, the stockbroker and the costs of the respective stock exchange are due. If you also take into account the costs for the bank and possible deposit management fees when calculating the return, the investor has the option of significantly increasing the net return by choosing a cheap deposit. The cheapest depots can be found in the following comparison.
Bonds are not shipped as effective pieces. These are purely accounting items.
Before purchasing, however, the investor should find out about the creditworthiness of the issuer. The Börsenzeitung is the official organ of the German stock exchanges and is therefore credible. It publishes all country rankings.
Calculate the yield on government bonds
The yield on a government bond does not necessarily have to correspond to the nominal interest rate. It depends on whether the investor is purchasing the bond at a price of 100 percent, less than 100 percent or more than 100 percent of the nominal value.
Assume that the nominal value is 10,000 euros, the term ten years, the interest rate three percent and the price corresponds to the nominal value. In this case, the return (excluding taxes and acquisition costs) is three percent.
- If the investor buys a government bond with an interest rate of three percent and a price of 98 percent one year before repayment, the return is five percent. He receives a one-off interest payment of three percent and makes a two percent profit when the paper is taken back.
- If he holds the bond for more than a year, the price gain must be divided by the number of years and added to the interest rate to determine the annual return.
- However, if the purchase is made at a price that is more than 100 percent of the nominal amount, he must subtract the premium from the interest in order to determine his return.
What alternatives are there to government bonds?
Anyone who is dissatisfied with the return can look around for alternative investment opportunities.
Time deposit offers in countries with top credit ratings offer a safe investment with good returns – as long as the investment amount does not exceed the cap of the country’s deposit protection fund.
Top credit countries include:
Great Britain and Sweden are also included, but for these countries the maximum amount hedged in euros varies due to currency fluctuations.
The portfolio mix enables ETFs (Exchange Traded Funds) to reduce risk and increase returns. In addition to bond ETFs, ETFs on broad indices such as MSCI World are also of interest. However, the long investment period is important: anyone who has invested in the 30 standard stocks of the DAX and held their shares for at least 15 years has never suffered losses, according to studies by the Deutsches Aktieninstitut.
Equity crowdfunding platforms as a return component
An alternative investment option can be crowdinvesting platforms such as Bergfürst , Exporo or iFunded. Here investors can participate in real estate projects with small amounts and have the chance of attractive returns. However, the risks should not be underestimated either. Investors should only invest if, in the worst case, they can cope with a total loss.
How do government bonds work?
Government bonds are “launched”. Example: On November 28, 2018, the federal government issues a bond for two billion euros with a term until August 15, 2028 and an annual interest rate of 0.25 percent. Investors can subscribe and purchase this bond. The proportions are so small that even small feeders are served. From the time of issue, the government bonds are traded on the stock exchange.
When due, the owner of the bond always receives back the nominal value at which the bond was issued. A calculation example: The price of a bond slips to 80 percent of its nominal value during the term. A buyer purchases the bond. However, 100 percent is required for repayment on the due date. The buyer can look forward to 20 percent additional profit on top of the interest received.
The maturities of government bonds vary, but are usually in the long-term range.
When issuing the bond, the issuer can set the issue price differently from the nominal value. If he wants to “attract” more investors, the issue price is, for example, 99 percent of the nominal value. If he knows that the bond will definitely be bought, he can reduce his interest burden by setting the issue price at perhaps 101 percent of the nominal value.
US government bonds
US Treasuries are known as “bonds” . Bond translates to loan. The full name is Treasury Bond, T-Bonds for short, where Treasury stands for the US Department of Treasury.
Treasury bonds have a term of between 10 and 30 years. In addition to these long-term securities, there are of course also fixed-income papers, so-called “Notes”, with a shorter term. The yield curve of US bonds when comparing the yields of short-term and long-term bonds is considered an economic indicator. The closer the yields of short-term and long-term bonds converge, the more critical the economy is. Long-term investments usually have higher interest rates than short-term investments.
Government bonds in Germany
In Germany, these papers are issued with a ten-year or 30-year duration. Of course, the Federal Republic of Germany also finances itself with shorter-term papers, but these then fall into other categories, for example federal bonds with a term of five years.
Bunds enjoy an excellent international reputation for the security of interest payments and repayment. In turbulent times, investors invest their money in German bonds, even if the interest rate is extremely low to negative. A negative interest rate arises in the case of short-term paper if the issue price has a premium that is higher than the interest rate.
Assess the risk of a government bond
Government bonds are like any other bond issuer in terms of risk. If he is solvent, the risk of a loss of interest or repayment to an issuer with a poor credit rating is reduced.
Based on Moody’s evaluation criteria, the risk assessment of a government bond should be made transparent for investors:
- Aaa – Reliable and stable debtors of the highest quality
- Aa – Good debtors, slightly higher risk than Aaa
- A – The overall economic situation must be taken into account
- Baa – medium-quality debtors who are currently acting satisfactorily
- Ba – Very dependent on the overall economic situation
- B – Financial situation is notoriously changeable
- Caa – Speculative, low debtor income
- Ca – as a rule, there are already payment disruptions here
- C – in arrears
- NR – not rated
Speculative bonds are considered high-yield bonds because the interest rate factors in the risk of default. The English expression for this is “Junk Bond”.
Moody’s also uses numerical appendices: “1”, “2” and “3” for the credit ratings Aa to Caa. The “1” means that the credit rating is in the upper third of the main grade. “2” and “3” stand for the middle and lower third.