Question

1. Use the bond market to address the following scenario. Assume the fiscal authority (government) decides to cut government spending, without changing taxes (run a smaller deficit). What do expect to happen to the price of government bonds? What do expect to happen to the yield to maturity on these bonds? Why do you think this is the case (that is, explain why the interest rate on these bonds either went up or down!)? Use a diagram to help explain your reasoning.

Answer 1

A government bond is a debt security issued by a government to support government spending and obligations. Government bonds can pay periodic interest payments called coupon payments. Government bonds issued by national governments are often considered low-risk investments since the issuing government backs them.

Government bonds may also be known as sovereign debt.

Government bonds are issued by governments to raise money to finance projects or day-to-day operations. The U.S. Treasury Department sells the issued bonds during auctions throughout the year. Some Treasury bonds trade in the secondary market. Individual investors, working with a financial institution or broker, can buy and sell previously issued bonds through this marketplace. Treasuries are widely available for purchase through the U.S. Treasury, brokers as well as exchange-traded funds, which contain a basket of securities.

Fixed-rate government bonds can have interest rate risk, which occurs when interest rates are rising, and investors are holding lower paying fixed-rate bonds as compared to the market. Also, only select bonds keep up with inflation, which is a measure of price increases throughout the economy. If a fixed-rate government bond pays 2% per year, for example, and prices in the economy rise by 1.5%, the investor is only earning .5% in real terms.

Local governments may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as municipal bonds, and often carry certain tax advantages for investors,

The U.S. vs. Foreign Government Bonds

U.S. Treasuries are nearly as close to risk-free as an investment can get. This low-risk profile is because the issuing government backs the bonds. Government bonds from the U.S. Treasury are some of the most secure worldwide, while those floated by other countries may carry a greater degree of risk.

Due to this nearly risk-free nature, market participants and analyst use Treasuries as a benchmark in comparing the risk associated with securities. The 10-year Treasury bond is also used as a benchmark and guide for interest rates on lending products. Due to their low risk, U.S. Treasuries tend to offer lower rates of return relative to equities and corporate bonds.

However, government-backed bonds, particularly those in emerging markets, can carry risks that include country risk, political risk, and central-bank risk, including whether the banking system is solvent. Investors saw a bleak reminder of how risky some government bonds can be during the Asian financial crisis of 1997 and 1998. During this crisis, several Asian nations were forced to devalue their currency which sent reverberations around the globe. The crisis even caused Russia to default on its debt.

The Uses of Government Bonds

Government bonds assist in funding deficits in the federal budget and are used to raise capital for various projects such as infrastructure spending. However, government bonds are also used by the Federal Reserve Bank to control the nation's money supply.

When the Federal Reserve repurchases U.S. government bonds, the money supply increases throughout the economy as sellers receive funds to spend or invest in the market. Any funds deposited into banks are, in turn, used by those financial institutions to loan to companies and individuals, further boosting economic activity.

Pros and Cons of Government Bonds

As with all investments, government bonds provide both benefits and disadvantages to the bondholder. On the upside, these debt securities tend to return a steady stream of interest income. However, this return is usually lower than other products on the market due to the reduced level of risk involved in their investments.

The market for U.S. government bonds is very liquid, allowing the holder to resell them on the secondary bond market easily. There are even ETFs and mutual funds that focus their investment on Treasury bonds.

Fixed rate bonds may fall behind during periods of increasing inflation or rising market interest rates. Also, foreign bonds are exposed to sovereign or governmental risk, changes in currency rates, and have a higher risk of default.

Some U.S. Treasury bonds are free of state and federal taxes. But, the investor of foreign bonds may face taxes on income from these foreign investments.

Pros

• Pay a steady interest income return

• Low risk of default for U.S. bonds

• Exempt from state and local taxes

• A liquid market for reselling

• Assessable through mutual funds and ETFs

Cons

• Offer low rates of return

• Fixed income falls behind with rising inflation

• Carry risk when market interest rates increase

• Default and other risks on foreign bonds

Real World Examples of U.S. Government Bonds

There are various types of bonds offered by the U.S. Treasury that has various maturities. Also, some return regular interest payments, while some do not.

Savings Bonds

The U.S. Treasury offers series EE bonds and series I savings bonds. Bonds sell at face value and have a fixed rate of interest. Bonds held for 20 years will reach their face value and effectively double. Series I bonds receive a semi-annually calculated secondary rate tied to an inflation rate.

Treasury Notes

Treasury notes (T-notes) are intermediate-term bonds maturing in two, three, five, or 10 years that provide fixed coupon returns. T-Notes typically have a $1,000 face value. However, two- or three-year maturities have a $5,000 face value. Although yields change daily, the 10-year yield closed at 2.406% March 31, 2019, and at that time had a 52-week range of 2.341% to 3.263%.

Treasury Bonds

Treasury bonds (T-Bonds) are long-term bonds having a maturity between 10 to 30 years. T-Bonds give interest or coupon payments semi-annually and have $1,000 face values. The bonds help to offset shortfalls in the federal budget. Also, they help to regulate the nation’s money supply and execute U.S. monetary policy. The 30-year Treasury bond yield closed at 2.817% March 31, 2019.

Treasury Inflation-Protected Securities (TIPS)

Treasury inflation-protected securities (TIPS) is a Treasury security indexed to inflation. They protect investors from the adverse effects of rising prices. The par value—principal—increases with inflation and decreases with deflation, following the Consumer Price Index. TIPS pay a fixed rate interest—determined on the bond's auction—on a six months basis. However, interest payment amounts vary since the rate applies to the adjusted principal value of the bond. TIPS have maturities of five, 10, and 30 years. March 29, 2019, the 10-year was auctioned with an interest rate of 0.875%.