Types of Bonds

Government Bonds

Government bonds are bonds that are issued by central governments. Governments issue bonds to borrow money to cover the gap between the amount they receive in taxes and the amount they spend; to re-fund existing debt; and/or to raise capital. Government bonds are usually considered the highest quality bonds in the market because they are backed by central governments (unless of course they are emerging market bonds where defaults are a serious risk in many cases). Most individual investors focus on buying and selling government bonds.

In Europe, Government Bonds are also called sovereign bonds. In the UK, Government Bonds are also called gilts; in France, OATs; in Germany, Bunds; in Italy, among other terms, BTPs. In the US, Government Bonds are also called US Treasuries or T-Bills.

Government Bonds that are most relevant to the discussions on the www.investinginbonds.eu website are in the chart below.

Investing in Bonds Europe Key Government Bond Types

Currency Country Type of Bond Website of Issuer
Pound sterling UK Gilts UK Debt Management Office
Euro France OATs Obligation Assimilable du Trésor Agence France Tresor
Euro Germany Bunds Bundesanleihe Finanzagentur GmbH
Euro Italy BTPs Buoni del Tesoro Polianuali Dipartimento del Tesoro
Euro Spain Letras del Tesoro Bonos/Obligaciones del Estado Tesoro Publico
US dollar US US Treasuries Issuer Bureau of Public Debt

National, sovereign governments issue bonds in order to borrow money to finance government operations and services and budget deficits. Bonds are issued with different coupon rates and different maturity dates. The coupon of a government bond is usually based on the credit rating of the country and the maturity date. Different yields for bonds of different countries reflect differences in perceived credit risk. 15 member states of the European Union have the Euro as a common currency. The remaining 13 including the the United Kingdom,Sweden and Denmark have their own currency.

Structure

When structuring bonds to meet the purpose, governments choose among different features such as:

Conventional or Straight bonds with a fixed coupon (usually paid on a semi-annual basis) and maturity date when the entire principal is repaid.

Floating rate bonds also called floating rate notes (FRN) are usually short to medium term issues, with a coupon interest rate that “floats,” i.e. goes up or down in relation to a benchmark rate plus some additional “spread” of basis points (each basis point being one hundredth of one percent). The reference benchmark rate is usually LIBOR (London interbank offered rate) or EURIBOR (Euro interbank offered rate). The “spread” added to that reference rate is a function of the credit quality of the issuer. Floating rate notes usually reference the central bank rate for government bonds.

Zero-coupon bonds do not have interest payments. The investor in this type of Eurobond may be looking for some kind of tax advantage or to grow their wealth as fast as possible for their risk profile.

Index linked bonds are described below.

STRIPS are described below.

Coupon rates of interest may be fixed rate or floating rates of interest. A fixed coupon bond will make regular fixed interest payments over the life of the bond. A floating rate bond has an interest rate that is reset periodically based on a benchmark rate such as LIBOR.

Yield

Yield is a critical concept in bond investing because it is the tool you use to measure the return of one bond against another.

In essence, yield is the rate of return on your bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates.

Here is an example of how yield works: You buy a bond, hold it for a year while interest rates are rising and then sell it. You receive a lower price for the bond than you paid for it because no one would otherwise accept your bond’s now lower-than-market interest rate. Although the buyer will receive the same amount of interest you did and will have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours was—because the buyer paid less for the bond.

There are numerous ways of measuring yield, but two—current yield and yield to maturity—are of greatest importance to most investors.

Current yield

The current yield is the annual return on the amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par-value bond paying 6% is 6%.

However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a global 1,000 bond with a 6% stated interest rate after prevailing interest rates have risen above that level, you would pay less than par. Assume the price that you paid is Euro 900. The current yield would be 6.67% (Euro 1,000 x .06/Euro 900).

Yield to maturity

A more meaningful figure is the yield to maturity, because it tells you the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realise (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).

Ask your financial advisor to provide you with the precise yield to maturity of any bond you are considering. Do not buy on the basis of the current yield alone, because it may not represent the bond’s real value to you.

Learn more about Using Math to Understand Bonds.

Yield to call

The yield to call tells you the total return you will receive if you were to buy and hold the security until the call date. As an investor, you should be aware that this yield is valid only if the bond is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date, and the market price of the bond.

Market Risks and Government Bonds

Although Government Bonds are usually considered high quality credit, not all Government Bonds are rated the same. Thus although some individual investors tend to think Government Bonds are always rated AAA and virtually free from credit risk, this is not the case in Europe. Consequently, investors face credit (ratings) risk in investing in Government bonds, since the ratings could be downgraded. Some Government Bonds such as German Bunds, US Treasuries and UK gilts have been considered virtually free from credit (ratings) risk, as the bonds are backed by the authority and taxing authority of the German, US or UK government and these governments are unlikely to default on their bonds.

However, all government bonds are affected by other types of risk, principally interest-rate risk and inflation risk. Investors who invest in a government bond that is not in his/her home currency also face currency/exchange rate risk since the value of his/her investment could go down as well as up depending on what happens to the currency exchange rate. For example, US dollar investments are worth less against European Euros and pounds sterling because the exchange rate has changed significantly between the dollar and European currencies.

Interest rate risk: While investors are effectively guaranteed to receive interest and principal as promised, the underlying value of the bond itself may change depending on the direction of interest rates. As with all fixed-income securities, if interest rates in general rise after a Government security is issued, the value of the issued security will fall, since bonds paying higher rates will come into the market. Similarly, if interest rates fall, the value of the older, higher-paying bond will rise in comparison with new issues. Interest rate risk is also known as market risk.

Inflation risk: In a period of low inflation and moderate shifts in interest rates, investors often are content to hold their bonds to maturity, ignoring the changes in market value of their bonds. However, some investors strive to structure their bond holdings to minimise market risks and take advantage of market opportunities. One such technique is called “laddering,” in which the portfolio is structured so that bonds mature at regular intervals, allowing the investor to make new choices with available cash.  Learn more about Risks

A note on index-linked Government Bonds: Many governments now issue inflation-indexed or index-linked bonds. Given that citizens need to save for retirement, a home and other needs, some potential bond investors want to preserve their purchasing power by investing in “inflation protection.” While inflation is lower now than at any time since the 1960s, many people are concerned that investments, including government bonds, may lose purchasing power over the long run. In recent markets, some US Treasury inflation linked bonds (TIPS) have experienced such high demand that real yield is 0% or below 0%. Since both principal and interest payments are linked to changes in consumer price indices, essentially investors are saying they are willing to give up money today in exchange for insurance against inflation tomorrow.

A prolonged period of declining interest rates and relatively low inflation has created a favourable scenario for traditional fixed-income investments. But the spectre of rising interest rates at some point in the future has many investors pondering strategies for just the opposite: an environment of high interest rates and escalating inflation, which could erode the relative value of most fixed-income investments.

Institutional investors, such as pension funds, mutual funds, unit investment trusts, endowments, insurance companies and others looking for diversification or to match liabilities also use these inflation-linked securities to help ensure their investment goals are met and to protect the value of their investments against inflation in the future.

 

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