A government bond is a way for the government of a country to finance its operations by borrowing money in exchange for fixed interest payments plus the return of the “principal” (initial money invested) at maturity (the end of the term of the loan). You can think of a government bond as government debt.
Example of a government bond
For example, if you lend $10,000 to the Australian government, you will receive a 2.5 per cent coupon rate for 10 years; at maturity, you will receive your initial investment back.
The critical elements in the last example are:
- Face value: Your initial investment, in this case, is $10,000.
- Coupon rate: 2.5 per cent.
- Maturity: the term of the loan, in this case, 10 years.
Investing in bonds will generally yield you a lower coupon rate than investing in corporate bonds because it is a government backing up the loan, so there is less risk. As a result, they may default (not repay the coupon or capital). Therefore, government bonds have a lower interest rate than other financial products as they are less risky, making them a great addition to your investment portfolio’s defensive strategy.
Benefits of Government Bonds
- Predictable income: You will earn regular interest (fixed income) for the life of your investment every six months.
- Lower risk of default: Your bonds are backed by a government.
- Security: The government will pay regular coupon interest and return your principal.
- Tradable: You can buy or sell your Exchange-traded Treasury Bonds (eTBs) anytime the Australian Securities Exchange (ASX) is open.
- Different maturities: There is a wide range of maturities to choose from.
Risks of Government Bonds
- Maturity length risk: the longer the maturity, the higher the risk, as there is more time for an adverse event to happen that affects the issuer’s ability to pay back. The longer the maturity, the higher the rate you should be offered, given that you would take on more risk.
- Credit risk (or default risk): the chance that the government that issues the bonds will not be able to repay the loan to you.
- Interest rate risk: The risk of buying the bond at the current rate and of rates increasing in the future, making your bond less valuable in the secondary market. This risk can be overcome by holding a bond until it matures or buying bonds with different durations.
- Market price risk: The market price of eTBs may vary over time in response to external factors like interest rates. If the interest rates increase, the price of an eTB will fall; meanwhile, if interest rates fall, the price of an eTB will increase. Therefore, if you sell your eTBs before maturity, you could lose some of your capital.
- Risk of conversion by the Australian Government: The Australian Government may convert holdings of eTBs to the underlying Treasury Bonds registered directly in the Commonwealth Stock Registry. If this happened, you would still receive your coupon payments, but you would be unable to sell your investment on the ASX. This could happen if the agreement between the Australian government and the ASX for trading Australian Government Bonds on the ASX ends.
How are government bonds sold?
Usually, when a government wants to issue bonds, it will do it through a bond auction where the main buyers are large banks or financial institutions. Then those institutions sell the bonds to pension funds, other banks, and individuals. There is also a secondary market for bonds, usually through banks.
What are Australian Government Bonds?
Australian Government Bonds (AGBs) are debt securities issued by the Australian government and are quoted on the Australian Securities Exchange (ASX). Exchange-traded AGBs enable you as an investor to own an AGB in the form of CHESS Depositary Interest (CDIs), which lets you receive coupon payments and principal. One unit holding of an eTB gives you a $100 Face Value of the Treasury bond.
Types of Australian Government Bonds (AGBs)
Retail investors can access Australian Government Bonds through “Exchange-traded bonds” (eAGBs), with two types of eAGBs available: exchange-traded Treasury Bonds (eTBs), which provide fixed interest payments, and exchange-traded Treasury Indexed Bonds (eTIBs) which provide you with interest payments that are linked to inflation.
Exchange Treasury Bonds (eTBs)
Exchange Treasury Bonds are debt securities issued by the Australian government. They are medium to long-term debt and pay an annual interest rate (usually semi-annually).
Exchange Treasury Indexed Bonds (eTIBs)
Exchange Treasury Indexed Bonds are also issued by the Australian government and have a medium to long term; however, their capital value is adjusted for movements in the “Consumer Price Index” (CPI). The CPI is an indicator of inflation that measures the change in the price of a basket of goods that households consume in terms of percentage. Treasury Indexed bonds pay interest at a fixed quarterly rate on the adjusted capital value. Upon maturity, investors receive the adjusted capital value they invested. In simple terms, the value of the bond adjusted according to how the CPI moved throughout the bond’s life.
Semi-government bonds (or Semis) are like “Australian Commonwealth Government Bonds” (ACGBs). However, they are issued by the state and territory governments. They have different ranges of maturities and pay regular interest.
They are debt securities issued by local governments.
How to invest in eTBs
Buying or selling eTBs on the ASX is like buying listed shares; they can only be purchased through licensed ASX brokers, so you need a sponsored CHESS account to buy and sell eAGBs. You can invest from a Face Value of $100 for an eTB or ETIB.
What is the Coupon Interest for eTBs?
The coupon rate on a Treasury Bond is set when a bond is first issued by the Australian government and remains fixed during the bond’s life. For example, a Treasury Bond with a 5 per cent Coupon rate will pay you $5 a year per $100 Face value in instalments of $2.50 every six months. These instalments are called coupon interest payments.
How are coupons paid?
Every six months. You will get paid the next day if your coupon date does not fall on a business day. You will receive your payment by direct credit into an AUD bank account with a financial institution in Australia.
What is Yield to Maturity (YTM)?
YTM is the rate of return of a bond expressed as an annual rate when you purchase a bond at its current market price and when held until maturity.
What is the difference between Coupon Interest Rate and YTM?
The yield to maturity will vary with changes in the price at which you purchase the bond. The coupon interest rate is set when the bond is first issued and stays fixed during the bond’s life. Therefore, the Coupon Interest rate will usually differ from YTM.
Government Bonds from the United States (US) Government (US Treasuries)
The bonds offered by the US Treasury are considered low risk as they are backed by the United States Government; because of their low risk, they usually pay low-interest rates. The US Treasury also issues these bonds to raise money to finance operations or projects. The US. Treasury Department sells issued bonds during auctions at set intervals during the year where prominent financial players submit their bids.
Treasury bills are considered a conservative investment and the last line of defence against any possible loss of principal as they are backed by the full faith and credit of the US government.
What are the three main categories of US Treasuries?
The three main categories of US Treasuries are Treasury Bills, Treasury Notes and Treasury Bonds.
Treasury Bills (T-Bills)
These bills have the shortest range of maturities among government bonds. They range from four weeks to fifty-two weeks. There is also a cash management bill with a maturity of only days. T-Bills are different, as they are issued at a discount and mature at par value; therefore, the difference between the price you bought it and the amount you get at the end is the interest paid on the T-Bill.
Treasury Notes (T-Notes)
These are middle-term notes, ranging from two to ten years in maturity; the Treasury auctions them every month. T-notes are issued at a $100 par value, mature at the same price, and pay interest twice a year.
Treasury Bonds (T-Bonds): These are called “Long Bonds”; they are just like T-Notes but mature in thirty years.
How can you buy US Treasuries?
They can be bought directly from the US government on the website, TreasuryDirect.gov, a bank, or a broker. Although they are considered low risk, they have some risks, like the impact of inflation and changes in interest rates. US Treasury securities also trade in the secondary market, and their prices fluctuate according to interest rates. For Australians, you will also be exposed to Foreign Exchange risk, as US Treasuries are traded, and coupons are paid in US dollars.
Foreign Government Bonds
Foreign government bonds may have a larger yield as they have more risk. Some issues to consider are whether the government of a foreign country has the financial stability to meet its obligations and how high the political risk is.
Disclaimer: This document is for educational purposes only. The information and any advice provided in this article has been prepared without considering your objectives, financial situation or needs. Because of that, you should, before acting on the advice, consider the appropriateness of the advice, having regard to those things.
Copyright © 2023 Australian Bond Exchange Pty. Ltd. (“ABE”). (ABN 73 605 038 935, AFSL 484453)
Contact us if you have any questions or would like any assistance.