What Is a Government Bond?

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A government bond is a debt security that a national, state or local government sells to raise money. The buyer lends money to the government. In return, the government promises to repay the full face value (the principal) on a set maturity date and, for most bonds, to pay interest along the way. The investor becomes a creditor, not an owner. That is the main difference between a government bond and a stock.

Governments use the proceeds to cover budget shortfalls, fund public services and infrastructure, and repay older debt as it comes due. In the United States, debt issued by the federal government is known as Treasuries. State and local governments issue municipal bonds.

How a Government Bond Works

A government bond is defined by a few terms set at issuance:

• Face (par) value: the amount the government repays at maturity. It is also the base for calculating interest.
• Coupon: the interest rate paid on the face value, usually fixed. A $1,000 bond with a 4% coupon pays $40 a year. With semiannual payments, that is two installments of $20.
• Maturity: the date the principal is repaid. It can be a few weeks away or 30 years away.
• Market price: what the bond trades for after issuance. This price can sit above or below face value.
• Yield: the return implied by the bond’s price. A buyer who pays less than face value earns a yield above the coupon rate. A buyer who pays more than face value earns a yield below it.

If you buy a bond and hold it to maturity, the price swings in between do not change your cash flows. You collect each coupon and get the face value back, assuming the issuer pays. If you sell before maturity, you receive whatever the market will pay that day, which may be more or less than you paid.

Interpreting a Government Bond

Prices and interest rates move in opposite directions. When market rates rise, newly issued bonds pay more, so an older bond with a lower fixed coupon has to sell at a discount to attract buyers. When rates fall, older bonds with higher coupons become more valuable and trade at a premium.

How far the price moves depends largely on how much time is left until maturity. A longer bond has more future payments locked at the old rate, so its price reacts more strongly to the same change in rates. The return measure that captures price, coupons and time together is yield to maturity.

Types of U.S. Government Bonds

Treasury bills (T-bills) are short-term securities with maturities from four weeks to 52 weeks. They pay no coupon. Bills are sold at a discount to face value (or at face value), and the investor receives the full face value at maturity. The difference between the two is the interest earned.

Treasury notes (T-notes) mature in two, three, five, seven or 10 years and pay a fixed coupon every six months. They can be bought in $100 increments.

Treasury bonds (T-bonds) are the long end of the market, with 20- or 30-year maturities. They pay interest semiannually and have a $100 minimum purchase.

Treasury Inflation-Protected Securities (TIPS) are issued in five-, 10- and 30-year maturities. Their principal is adjusted with the Consumer Price Index: it rises with inflation and falls with deflation. The coupon rate is fixed at auction, but it is applied to the adjusted principal every six months, so the dollar amount of each payment changes with inflation.

U.S. savings bonds are sold directly to individuals and cannot be traded in the secondary market. Series EE bonds earn a fixed rate, and the Treasury guarantees that an EE bond held for 20 years will be worth at least double its purchase price. Series I bonds combine a fixed rate with an inflation rate that is reset every six months.

Municipal bonds (“munis”) are issued by states, cities, counties and other local authorities to pay for projects such as schools, roads, libraries and parks. They are backed either by tax revenue (general obligation bonds) or by income from a specific project, such as tolls from a toll road (revenue bonds). Interest on many munis is exempt from federal income tax, and sometimes from state and local tax as well. Their stated rates are often lower than those of comparable corporate bonds, partly because of that tax treatment.

Example of a Government Bond

Hypothetical example, for illustration only.

An investor buys a newly issued Treasury note with a $1,000 face value and a 4% fixed coupon. It pays $20 every six months. Held to maturity, the investor receives every $20 coupon and the $1,000 principal at the end, whatever rates do along the way.

Sold early after rates rise: suppose that, with two years left, comparable new notes yield 5%. A buyer will only pay a price that gives them 5% on the old note’s remaining payments: three coupons of $20 plus a final $1,020. Discounting each at 2.5% per half-year:

• $20 / 1.025 = $19.51
• $20 / 1.025² = $19.04
• $20 / 1.025³ = $18.57
• $1,020 / 1.025⁴ = $924.07

The total is about $981.19. The investor who sells now takes a loss of roughly $19 on the principal, even though the government has not missed a single payment.

Inflation’s effect: a fixed-rate bond paying 2% a year while consumer prices rise 1.5% delivers a real return of only about 0.5%. If inflation runs above the coupon, the bond loses purchasing power.

Why Is a Government Bond Important?

For governments, bonds are the main way to borrow. In the United States, the national debt is largely the face value of outstanding Treasury securities. It has two parts: debt held by the public and intragovernmental holdings, such as debt owed to trust funds.

For monetary policy, the Federal Reserve buys and sells Treasuries to influence the money supply. When the Fed buys bonds, sellers receive cash they can spend, invest or deposit, and banks can lend those deposits to businesses and households. When the Fed sells bonds or lets its holdings run off, it does the reverse. This is separate from the Treasury itself buying back its bonds before maturity to retire debt early.

For markets, Treasury yields serve as a benchmark. Because U.S. federal debt is treated as close to default-free, analysts measure other securities by how much extra yield they offer above Treasuries. The 10-year Treasury yield also feeds into the rates on many loans.

For investors, government bonds offer predictable income and principal repayment. They often provide ballast next to stocks in a portfolio. Banks, insurers, pension funds, mutual funds, foreign governments, corporations and individuals all hold them.

Foreign Government Bonds

Most national governments issue bonds. Common examples:

• Gilts: United Kingdom
• Bunds: Germany
• OATs: France
• JGBs: Japan

Risk varies widely from one issuer to another. Bonds from emerging-market governments can carry political risk, central bank risk and a higher chance of default. Bonds denominated in a foreign currency add exchange-rate risk: a loss in the currency can erase the interest earned, as the forced devaluations of the 1997 and 1998 Asian financial crisis showed.

How to Buy Government Bonds

There are three main routes:

1. Direct from the Treasury. U.S. bills, notes, bonds and TIPS are sold at scheduled auctions throughout the year, and the auction allocates bonds until the offering is filled. Individuals can bid through TreasuryDirect, which also sells savings bonds.
2. Through a broker or bank. You can buy at auction or purchase previously issued Treasuries in the secondary market. Municipal bonds are generally bought through a broker.
3. Through funds. Mutual funds and exchange-traded funds (ETFs) that hold Treasuries offer exposure without picking individual bonds. A fund has no single maturity date, so there is no fixed principal repayment. Its value moves with its holdings, reflected in its net asset value.

Limitations of a Government Bond

• Lower returns. Low default risk comes with yields usually below what riskier assets, such as stocks or corporate bonds, aim to deliver.
• Interest rate risk. A fixed-rate bond sold before maturity can lose value when rates rise, and longer maturities lose more.
• Inflation risk. Fixed coupons can buy less over time. TIPS and I bonds address this, but at their own stated rates.
• Default and currency risk outside the U.S. Some governments have defaulted on their debt or forced investors to absorb losses.
• Liquidity varies. Treasuries are easy to sell before maturity. Savings bonds cannot be sold to other investors at all, and smaller municipal issues may trade infrequently.

FAQs

The Bottom Line

Government bonds matter to investors who want predictable income and principal repayment, often as ballast next to stocks. Holding a bond to maturity locks in its cash flows, while selling early exposes you to rate moves, and fixed coupons can lose purchasing power to inflation. Treasuries, TIPS, savings bonds, munis and bond funds each trade off liquidity, tax treatment and inflation protection differently.