What is a government bond?

One of the most popular low-risk investment opportunities for people with idle money is government bonds. But what does it mean and how does it work?

What is a government bond?

A government bond is a financial instrument the government issues to fund its commitments and expenditures. Government bonds provide bondholders with monthly interest payments called coupon payments.

Because the government backs them, investments in government bonds are seen as low-risk. Government bonds usually pay modest interest rates because they carry comparatively little risk.

How government bonds work

Taxes provide income for governments, which is then used to fund infrastructure, security, health care, and other services. They may issue bonds to assist in paying for certain projects or when they don’t have enough money to meet their expenditures.

Investors buy government bonds because they provide a dependable income stream and are often seen as having little risk to safeguard the initial investment. The danger that market interest rates may rise in exchange for this low volatility means that bondholders may end up with bonds that pay less interest than those that were issued more recently.

Put another way, the bond yield falls, which is calculated by dividing the coupon rate by the bond’s face value. This is most relevant if you want to sell the bond before it matures.

A bond that was bought earlier and has a greater coupon rate will increase in value on the open market if market interest rates decline. For instance, a Treasury bond with a 3% payment becomes more valuable than freshly issued bonds paying 2% if an investor purchases it and a year later the market interest rate falls to 2%.

The price of the bond will probably be greater than it was a year ago when freshly issued bonds were also paying 3% if the investor sells it before it matures.

Types of government bonds 

1. Municipal Bonds

To finance parks, libraries, and infrastructure, local governments issue municipal bonds. These “munis” sometimes come with tax breaks and benefits for investors. Munis may be financed by municipal taxes or the proceeds from a project like a toll road.

Municipal bonds typically have lower interest rates than riskier options like equities or corporate bonds.

2. Treasury Bills

Sometimes known as T-Bills, they are securities with a four- to 52-week period. Bills may be purchased at face value or a discount. Investors get their face value back when the bill matures.

3. Treasury Notes (T-Notes):

These are fixed coupon bonds with intermediate maturities of two, three, five, or ten years. 

4. Treasury bonds

Often known as T-bonds, they are long-term securities having a 20–30-year maturity. The bonds are used to cover budget deficits in the federal government. They also assist in carrying out monetary policy and controlling the country’s money supply.

Features of government bond

• Face value: The amount that bondholders loan the government and the amount they will get back when the bond matures is known as the face value or par value.
• Coupon: The interest that bondholders get regularly.
• Yield: The bond’s interest rate after deducting the market price.
• Market Price: The bond’s secondary market price, which might be different from face value.
• Maturity date: The day the issuer will repay the bondholder the bond’s face value is known as the maturity date.
• Current yield: The yearly coupon payment divided by the bond price is the current yield.

How to purchase government bonds in Nigeria?

The Debt Management Office (DMO) on behalf of the Government will hold the first main auction. The secondary market is where certain bonds are exchanged. Through this marketplace, individual investors may purchase and sell bonds that have already been issued. 

Investors may bid on specific bonds they want to purchase by quoting interest rates in an auction method used to sell FGN bonds. Therefore, bond applications may be allowed if their interest rates are less than the minimal average interest rate, also known as the reported marginal rate, and rejected if they are greater. 

Bond investments are made possible by Primary Dealers/Market Makers (PD/MMs). PD/MMs may include brokers, investment firms, banks, and so on. You fill up a form and approach the PD/MMs of your choice to invest. You fill out the form with your personal information, bank account information for interest payments, CSCS number, desired investment amount, bid interest rate, and signature. A minimum investment of N10,000 and further multiples of N1,000 are allowed.

The maturity periods of FGN Bonds range from five to twenty years. When government bonds are purchased and held to maturity, investors get monthly interest payments in addition to a return on their original investment. 

Pros and cons of investing in government bonds 

The holder of government bonds has both benefits and drawbacks. These loan instruments often provide a consistent flow of interest revenue. However, since there is less risk involved, this return is often smaller than that of comparable goods on the market.

Because of the high level of liquidity in the bond market, holders may readily resell their bonds on the secondary bond market. Certain mutual funds and exchange-traded funds concentrate their investments on Treasury bonds.

Bonds with fixed rates may lag when market interest rates rise or inflation increases. In addition, foreign bonds have a greater default risk and are subject to fluctuations in currency rates, sovereign or governmental risk, and other factors. 

Pros 

• Tax-Free Income: Interest earned on FGN Bonds is exempt from corporate income tax, withholding tax, and other taxes.
• Free from default risk: the FGN Bond’s maturity guarantees repayment.
• Collateral for borrowing: To obtain funds, the FGN Bond may be used as collateral.
• Provide a consistent source of income: Bonds provide a predictable source of revenue via semiannual or annual interest payments.
• Easily accessible: Anyone can buy bonds either directly from the Debt Management Office (DMO) or secondary marketplaces like commercial banks. 
• Liquidity: Easily Tradable due to its special ability to be traded over the counter (OTC) and listed on the Nigerian Stock Exchange. Bonds may be readily traded on the secondary market, but not necessarily at a profit, and are not required to be held until maturity.

Cons

• Relatively low rates of return: When it comes to bonds, particularly in comparison to equities, the adage “low risk, low return” is most typically accurate.
• Interest-rate risk: A bond with a lower interest rate will lose value on the secondary market if market interest rates rise.
• Default and currency risk: An investor purchasing bonds issued by foreign nations may be exposed to risk due to political or economic unrest in those nations as well as variations in the value of those nations’ currencies relative to the US dollar. A bond paying in a currency that does not have a history of holding its value may not be a good bargain even if a high interest rate is offered.
• Bond returns may not keep up with the pace of inflation: The possibility that the value of the currency a bond pays out could decrease over time is known as inflation risk. 

Why does Nigeria’s Federal Government issue bonds?

For the following reasons, the Federal Government of Nigeria (FGN) issues bonds:

1. To find sustainable and non-inflationary ways to fund government budget deficits.
2. To strengthen the government’s financial restraint.
3. To refinance the Federal Government’s maturing debt commitments.
4. The benchmark yield curve is created and used as a guide for pricing bonds issued by other organizations, particularly those in the private sector.
5. To create and maintain long-term liquidity in the domestic bond market.
6. To improve and expand the public’s savings and investment options.
7. To maintain the growth of additional bond market categories.
8. To broaden the range of government funding sources.

Conclusion

Government bonds have lower yields but provide an almost risk-free investment option. Since the government will eventually buy back your investment, you have nothing to lose when you buy government bonds.