Government bonds are fixed income securities issued by a government to support their spending and monetary policies. These bonds pay periodic interest payments known as coupons in addition to the principal upon maturity of the bond. Government bonds are categorized as low risk investments as the likelihood of default on payment by the government is very low. Government bonds are also known as sovereign bonds.
Bond Ratings
Throughout the year, the government would hold auctions in order to sell their bonds. The creditworthy of a government would determine the success of their auctions. Various international credit rating agencies will provide ratings about each country. Ratings act like a credit score and bonds with AAA rating are usually considered safe.
Open Market Operations
Through the usage of government bonds and other securities, the government is able to manage their monetary policy. This is known as open market operations, a commonly used tool by government bodies around the world. Through open market operations, the government would buy or sell securities in order to influence money supply, level of interest rates and the behavior of the overall economy.
Expansionary Monetary Policy
A central bank would use an expansionary monetary policy in order to stimulate the growth of the economy. This would the injection of a money supply into the economy. This injection would boost consumer spending and increase capital investment.
Expansionary monetary policy tools involve decreasing interest rates, reducing capital reserve requirements and buying back government securities.
- Decreasing Interest Rates – The government would adjust and reduce short term interest rates. This would enable banks to borrow short term loans in order to fund their liquidity needs. These low interest rates would reduce the cost of borrowing for banks. Lower cost of borrowing for banks would mean a lower interest rate for consumers. A lower interest rates would increase the money supply in the economy.
- Lower Reserve Requirements – Banks are obligated to hold a set amount of reserves with a central bank. When the central bank is looking to increase the money supply, they would lower the reserve requirements for the bank. This in turn would result in more loans handed out to consumers at low interest rates. More loans would increase the money supply in the economy.
- Buy Government Bonds – To increase the money supply, the government may use open market operations and buy back large amounts of government bonds from institutional investors. This purchase of government bonds would mean more money in the pockets of investors that they can spend, boosting the money supply.
Through an expansionary monetary policy, the government is able to:
- Boost Economic Growth – Reducing the cost of borrowing would encourage citizens to spend more and encourage businesses to invest in larger projects.
- Increase Inflation – Increasing the money supply would also increase inflation. This would result in a higher price of goods and services.
- De-value Currency – Boosting the money supply in the economy would reduce the value of domestic currency. This currency devaluation would mean more exports to foreign countries. Foreign countries would be able to buy more products from the domestic country and contribute to the increase of the money supply.
- Create Jobs – As exports and capital investments are increasing, this would result in extra jobs available for the consumer. There is a positive correlation with an expansionary monetary policy and reduction in unemployment.
Contractionary Monetary Policy
When the government is looking to cool down a overheating economy, they will embrace a contractionary monetary policy. This type of policy is intended to lower the money supply in the economy and fight inflation. A high inflation is an indicator of an economy running at full capacity. To reduce the inflation, the government would typically increase the interest rates, raise bank reserve requirements and sell government securities.
- Increase Interest Rates – The central bank would aim to reduce the money supply by increasing the interest rates. This would result in less borrowing by consumers as banks would raise interest rates that they charge to clients.
- Increase Reserve Requirements – Banks are required to hold a minimum amount of financial reserves with the central bank. To reduce the money supply, the central bank would raise the reserve requirements. This would affect the number of loans that banks can hand out to consumers.
- Sell Government Securities – The government would reduce the money supply by selling government bonds to institutional investors. This open market operations would reduce the amount of money circulating in the economy.
Through a contractionary monetary policy, the government is able to:
- Reduce Inflation – Through a tightening monetary policy, the government’s goal is to reduce inflation and cool down the economy. By reducing the money supply, the prices of goods and services can be stabilized.
- Cool Down Economic Growth – The reduction of money supply cools down the economy. Consumers and businesses lower their spending and capital investments which in turn slows down production of goods and services.
- Increase Unemployment – The cooling down of the economy comes at an expense of increased unemployment. As companies slow down their production of goods and services, this in turns causes a rise in unemployment as less people are spending. Unemployment and contraction monetary policies are positively correlated.
Government Bonds Risks
When it comes to investing, there are risks involved. The same could be said for government bonds which most people consider them to be risk free but that is not the case. Government bonds may be susceptible to:
- Interest Rate Risk
- When interest rates rise the price of bonds decline. Interest rates also affect economic activity and borrowing costs.
- Default Risk
- Investing in government bonds could expose you to default risk especially if the government bonds are rated poorly by a credit agency. The government may default and not return you your principal.
- Inflation Risk
- Higher prices lower the purchasing power of your investments. If your investment returns don’t exceed inflation you are losing purchasing power. The government should try to monitor inflation through fiscal and monetary policies.
- Liquidity Risk
- If you need to sell an investment you may not be able to find a buyer in a timely manner. This surely would depend on the credit rating of the government itself.
- Regulatory / Political Risk
- Governments have a large effect on social stability and the economic environment for investment. It’s important the government has business friendly policies.