A government bond is a type of debt-based investment, where you loan money to a government in return for an agreed rate of interest. Governments use them to raise funds that can be spent on new projects or infrastructure, and investors can use them to get a set return paid at regular intervals.
How do government bonds work?
When you buy a government bond, you lend the government an agreed amount of money for an agreed period of time. In return, the government will pay you back a set level of interest at regular periods, known as the coupon. This makes bonds a fixed-income asset.
Once the bond expires, you will get back your original investment. The day on which you get your original investment back is called the maturity date. Different bonds will come with different maturity dates - you could buy a bond that matures in less than a year, or one that matures in 30 years or more.
Example: Say, for instance, that you invested $10,000 into a 10-year government bond with a 5% annual coupon. Each year, the government would pay you 5% of your $10,000 as interest, and at the maturity date they would give you back your original $10,000.
Types of government bond
The terminology surrounding bonds can make things appear much more complicated than they actually are. That is because each country that issues bonds uses different terms for them. Some call them gilts and some treasuries. Treasuries come in three broad categories, according to their maturity:
- Treasury bills (T-bills) expire in less than one year
- Treasury notes (T-notes) expire in one to ten years
- Treasury bonds expire in expire in more than ten years
One can also buy government bonds that don’t have fixed coupons – instead, the interest payments will move in line with inflation rates. In the UK these are called index-linked gilts, and the coupon moves with the UK retail prices index (RPI). In the US, they are called treasury inflation-protected securities (TIPS).
Factors that affect the prices of government bonds
Supply and demand
Just like any financial asset, government bond prices are dictated by supply and demand. The supply of government bonds is set by each government, who’ll issue new bonds as and when they are needed. Demand for bonds is dependent on whether the bond looks like an attractive investment.
Interest rates can have a major impact on the demand for bonds. If interest rates are lower than the coupon rate on a bond, demand for that bond will rise as it represents a better investment. But if interest rates rise above the coupon rate of the bond, demand will drop.
How close the bond is to maturity
Newly-issued government bonds will always be priced with current interest rates in mind, meaning that they’ll usually trade at or near their par value. And by the time a bond has reached maturity, it’s just a pay out of the original loan – meaning that a bond will move back towards its par value as it nears this point. The number of interest rate payments remaining before a bond matures will also have an impact on its price.
Government bonds are usually viewed as low-risk investments, because the likelihood of a government defaulting on its loan payment tends to be low. But defaults can still happen, and a riskier bond will usually trade at a lower price than a bond with lower risk and a similar interest rate.
Government Bond Risks
One might hear investors say that a government bond is a risk-free investment. Since a government can always print more money to meet its debts, the theory goes, one will always get their money back when the bond matures. In reality, the picture is more complicated. Firstly, as we’ve seen with Greece’s debt crisis, governments aren’t always able to produce more capital. And even when they can, it doesn’t prevent them from defaulting on loan payments.
But aside from credit risk, there are a few other potential pitfalls to watch out for with government bonds: including risk from interest rates, inflation and currencies.
Interest rate risk
Interest rate risk is the potential that rising interest rates will cause the value of your bond to fall. This is because of the effect that high rates have on the opportunity cost of holding a bond when you could get a better return elsewhere. Interest rate risk, however, remains high in the Zimbabwean economy because of the volatility in liquidity within the financial markets.
Inflation risk is the potential that rising inflation will cause the value of your bond to fall. If the rate of inflation rises over the coupon rate of your bond, then your investment will lose you money in real terms. Index-linked bonds can help mitigate this risk.
Currency risk only applies if you buy a government bond that pays out in a different currency to your reference currency. If you do this, then fluctuating exchange rates may see the value of your investment drop.
How to get started with government bonds
When a government wants to issue bonds, it will usually do so via a bond auction, where the bond will be bought by large banks or financial institutions. Those institutions will then sell the bonds on, often to pension funds, other banks, and individual investors. Sometimes, governments sell bonds directly to individual investors.
Zimbabwe's Government bonds
The Reserve Bank of Zimbabwe lifted its overnight lending rate to 35% from 15% during an unscheduled meeting in June of 2020, aiming to curb inflationary pressures and stabilize the exchange rate amid the continued devaluation of the currency.
The Government of Zimbabwe has since the beginning of 2014 to 30 May 2014, been issuing treasury bills in all shapes and sizes with the largest of batch being worth US$103 million to clear the Reserve Bank of Zimbabwe (RBZ)'s debt to banks and farmers.
In an economy which Government has full control over its monetary policy, treasury bills would be deemed next to risk-free because Government can always print money, as a last resort, to repay bondholders when faced with an imminent default. The introduction of the multi-currency regime in Zimbabwe has meant that the RBZ cannot print money when faced with a default and in the absence of foreign currency reserves this means that there is no security for Government’s issuance of treasury bills in US dollars.
The Zimbabwe government had sought to raise $490 million between August 2019 to October 2019 via public Treasury Bills (TBs) auction to finance its activities with analysts warning the cash-strapped Treasury not to squeeze out financial institutions and unsustainably raise money supply. This came after the central bank issued $300 million Treasury Bills on 2 October 2019 to finance numerous activities, a week after the apex bank issued public auctions of the sovereign paper to raise $100 million.
The TBs auction system resumed in August, with two auctions carried out in that month which were oversubscribed. The first and second TBs auctions raised $30 million and $60 million, respectively. According to the RBZ notice, investors were restricted to a maximum of two applications, of a minimum $1 million each.
“The Reserve Bank of Zimbabwe (RBZ) hereby invites financial institutions including commercial banks,building societies, POSB and Infrastructure Development Bank of Zimbabwe to subscribe to Treasury Bills amounting to three hundred million (ZWL$300 000 000),” RBZ said. While the three previous auctions had a 90-day tenure, the current TBs had 365 days tenure and had open tender on a yield basis.
Prior auctions were held in secrecy, and as such, government instituted an open market borrowing to improve transparency on its domestic debt.
The huge quantity of TBs issued during the period 2017 to June 2018 had posed a burden to the fiscus in terms of both interest and principal payments and in some instances it caused a situation where the TBs were being reduced at absurd rates in the secondary market, hence undermining market confidence in government securities.
During the period 2017 to June 2018 government issued Treasury Bills and Bonds amounting to $4,3 billion to cover the financing gap. The stock of outstanding Treasury Bills as at June 2018 is $6,7 billion, with a maturity value of around $8,3 billion.
- , IG, Accessed: 14 August, 2020
- , Trading Economics, Accessed: 14 August, 2020
- Zimnat Asset Management, , The Herald, Published: 30 May, 2014, Accessed: 14 August, 2020
- , Reserve Bank of Zimbabwe, Accessed: 14 August, 2020
- Fidelity Mhlanga, , Newsday, Published: 3 October, 2019, Accessed: 14 August, 2020