Tue. Oct 4th, 2022
infographic government bonds

Have you ever borrowed money? If you haven’t done it, you probably know someone who has. Borrowing money is a normal part of our society and a situation that all people have to go through. companies. Even governments do it. Do you know how they can do it? By issuing government bonds. This article explains what you need to know about investing in government bonds if you have considered or are thinking about doing so.

When a government issues a bond, it requires you to invest a certain amount of money. It then promises to repay that investment with interest over time. Here we delve into the world of bond investing to help you decide whether bonds are right for your portfolio. However, as many experts advise, the best option for savers is diversification, which is why many people supplement their bond investments with bank deposits.

Types of bonds

There are many types of bonds, depending on their characteristics, but we will start by dividing them into two broad groups

  1. Bonds issued by governments or institutions. A type of debt-based investment that lends money to a government in exchange for an agreed interest rate. They are usually safer than bonds issued by companies, but also offer lower yields. This is an example of a government bond.

You invest 10,000 euros in a 10-year government bond with an annual interest rate (yield) of 4%. This means that the government will pay you 4% interest on €10,000 each year, and you will repay the initial investment at the end of the specified period.

  1. Bonds issued by companies. They usually offer a higher yield than government bonds, but are less reliable. The yield may be higher or lower depending on the strength and growth of the company issuing the bond.
infographic government bonds

Managers have found investment opportunities in corporate bonds.

Other types of bonds

  • Exchangeable bonds: can be exchanged for existing shares of a company.
  • Convertible bonds: can be exchanged for new issues with lower yields.
  • Non-coupon bonds: no monthly interest is paid, but transitional interest is paid at maturity.
  • Perpetual bonds: they are non-refundable, so the principal invested is not repaid. However, the interest in them is constant.
  • Treasury bonds: issued by companies to cover their cash needs. They return the capital invested.
  • Bond: The value of a bond is divided into the individual payments it generates, so that interest and principal can be traded separately.
  • Social bond: A bond designed to finance projects to solve a specific social problem.
  • Green bonds are bonds designed to finance or refinance environment-related projects. The first green bond was just issued in Spain in September this year. A 20-year bond for environmental projects. The government has identified more than €13.6 billion as green spending.
  • Sustainability-linked bonds: bonds linked to the achievement or improvement of specific environmental, social, or governance measures.
  • Inflation-linked bonds: returns based on future inflation. They have the same characteristics as traditional bonds and have the advantage of protecting the value of your savings.
  • Junk bonds: High-risk, low-rated bonds, usually with high yields and rewards commensurate with the risk. Also known as high-yield bonds, their creditworthiness is an investment risk because there is a high probability that the issuer will default.

What is a government bond?

When a government issues sovereign debt, it does so to cover a shortfall in the national budget. Government bonds are long-term securities issued by the government for this purpose. When you buy a bond, you lend the government a certain amount of money for a predetermined period of time. In return, the government agrees to pay you regular interest at a predetermined rate until the bond matures, and to repay the principal at maturity.

For example, suppose you decide to buy a 10,000 euro government bond at an annual interest rate of 3% and, in return, the government agrees to pay you 10,000 euros in interest every six months and to pay you back 10,000 euros at the end of the 10-year term.

Of course, there are exceptions, such as zero coupon bonds. They do not earn interest, but are sold at a price lower than their face value. However, most government bonds follow the same formula: you invest a certain amount of money, receive interest and get your money back at maturity.

Government bonds or treasury bills?

Some people confuse government bonds and treasury bills. The main difference between the two is the date of issue. Therefore, whether you invest in one or the other depends largely on how long you want to recoup your investment.

Treasury bills: Mainly issues with a maturity of 18 months or less. A discount method is used whereby Treasury bills are purchased and repaid at maturity less the prevailing interest rate.

Government bonds: Government bonds are at the other extreme. They can be purchased fully or partially paid and receive regular quarterly, semi-annual, or annual payments. Thus, the notional amount plus the last coupon is repaid at the end of the maturity period.

Before investing in treasury bills or government bonds, it should be borne in mind that the investment product of choice for Spaniards is the bank deposit because of its safety. Investing in treasury bills, for example, is more advantageous in times of crisis, as yields tend to be higher when the treasury is in financial difficulty. Deposits, on the other hand, can offer stable returns, as can be seen on the Credit Suisse website.

infographic Treasury Letters

Advantages of investing in government bonds

A secure investment

The advantage of holding government bonds in your portfolio is that they are a relatively safe investment, although not as safe as bank deposits. The value of bonds tends not to fluctuate as much as shares, so there is less concern about fluctuations in value. However, if you are really looking for security, you may prefer to choose a long-term savings account or a bank deposit.

A predictable source of income

Another advantage of bonds is the predictability of their income stream. Bonds pay a fixed amount of interest twice a year, so you can usually expect that money to arrive on schedule. Government bonds and treasury bills also have the advantage that the interest is tax-exempt to varying degrees.

Investing in society

Some investors also prefer municipal bonds because they offer the opportunity to invest locally. By investing in municipal bonds, you can help improve the local school system, build a hospital or create a community garden. It is this social aspect, and the possibility that the interest is completely tax-free, that has led some investors to abandon the high interest rates of other corporate bonds and invest in government bonds.

Are bonds risky?

Conservative investors prefer bonds to equities as a less risky asset. After all, if you issue a bond and hold it to maturity, you will theoretically get your money and the contractual interest rate, unless it is issued with a negative yield. If, on the other hand, you decide to invest in the stock market and buy shares, you will not know how much money you will make until the transaction is completed.

However, fixed-income assets, such as bonds, also have their own risks. For example, if you want to dispose of an asset in the secondary market before its maturity, you can sell it for less than its face value or sell it at a premium for a higher profit.

These are the risks associated with bonds.

  • Credit risk: The risk that the bond issuer will not be able to meet its payment obligations to bondholders. Corporate bonds have a higher credit risk than government bonds.
  • Market risk: The possibility that the value of bonds may fall due to a rise in interest rates.
  • Currency risk: For bonds denominated in the local currency, the exchange rate of the currency pair may affect the final yield of the bonds.
  • Inflation risk: The risk that the inflation rate will rise faster than the bond coupon and that the bond yield will not equal or exceed the inflation rate, resulting in a negative real return.

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