When it comes to trading stocks, shares, and bonds, getting your head around all the terminology can feel extremely daunting – especially for beginners who are just starting out in that field. Even for the experts, there is a certain amount of risk attached to entering the market, which means it pays to be careful and considered in your decision making.
Government bonds are an alternative to trading on the traditional stock market and provide investors with another option to add to their portfolio. But what are government bonds, how do they work and what are the pros and cons of dealing in them? Here’s a handy guide to help you figure it all out.
What are government bonds?
Governments issue bonds as a way of borrowing money in order to pay their bills. These bonds are purchased by the likes of investors, banks, pension funds, insurers, and individuals. Of course, these investors are buying these bonds in order to make a return. In the UK, government bonds are known as ‘gilts’, but other countries have different names for them. In the US, they are known as ‘treasuries’.
For example, the UK government is set to issue ‘green’ government bonds later in 2021. The money received from the sale of those bonds is to be put towards green investment – something which other European countries have already started doing.
How do government bonds work?
Investors earn their returns in the form of interest payments, which are made periodically. But when they receive their money back in full will depend on the maturity of the bonds. That maturity could be set at anything from a few months to a number of years and essentially reflects the length of time the government is giving itself to repay its investors. Those with short-term maturity dates are generally perceived as lower risk, while longer-term bonds are seen as riskier because there is a greater period of time over which things can go wrong.
Why invest in government bonds?
Of course, with almost any form of financial investment, there is risk attached and government bond trading is no different in that regard. But there are plenty of advantages that attract investors. For example, they can make for steady returns in the form of periodical interest payments, and typically they are at lower risk of default because they are backed by the government. Additionally, owners of government bonds will incur no capital gains taxes.
What are the risks of investing in government bonds?
One of the drawbacks of trading in government bonds is that they offer relatively low rates of return. Another issue is that the fixed rate of income can fall behind the rising rate of inflation, while there are also examples of yields rising to the point that governments struggle to pay their investors back in full. A few years ago, Greece’s government bond yields soared amid concerns about the International Monetary Fund’s role in bailing out the country’s debt.
Although generally regarded as lower risk, stories such as Greece’s should serve as a warning to those interested in trading in government bonds.