How do government bonds work

On a set schedule, whether quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested in other bonds. Stocks can also provide income through dividend payments, but dividends tend to be smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments. Capital appreciation : Bond prices can rise for several reasons, including a drop in interest rates and an improvement in the credit standing of the issuer.

However, by selling bonds after they have risen in price — and before maturity — investors can realize price appreciation, also known as capital appreciation, on bonds. Capturing the capital appreciation on bonds increases their total return, which is the combination of income and capital appreciation.

Investing for total return has become one of the most widely used bond strategies over the past 40 years. Diversification : Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to reduce the risk of low, or even negative, returns on their portfolios. Potential hedge against an economic slowdown or deflation : Bonds can help protect investors against an economic slowdown for several reasons.

The price of a bond depends on how much investors value the income the bond provides. Inflation usually coincides with faster economic growth, which increases demand for goods and services. On the other hand, slower economic growth usually leads to lower inflation, which makes bond income more attractive.

An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as a source of return. If the slowdown becomes bad enough that consumers stop buying things and prices in the economy begin to fall — a dire economic condition known as deflation — then bond income becomes even more attractive because bondholders can buy more goods and services due to their deflated prices with the same bond income.

As demand for bonds increases, so do bond prices and bondholder returns. In the s, the modern bond market began to evolve. Supply increased and investors learned there was money to be made by buying and selling bonds in the secondary market and realizing price gains. Until then, however, the bond market was primarily a place for governments and large companies to borrow money. The main investors in bonds were insurance companies, pension funds and individual investors seeking a high quality investment for money that would be needed for some specific future purpose.

As investor interest in bonds grew in the s and s and faster computers made bond math easier , finance professionals created innovative ways for borrowers to tap the bond market for funding and new ways for investors to tailor their exposure to risk and return potential. The U. Broadly speaking, government bonds and corporate bonds remain the largest sectors of the bond market, but other types of bonds, including mortgage-backed securities, play crucial roles in funding certain sectors, such as housing, and meeting specific investment needs.

Gilts, U. A number of governments also issue sovereign bonds that are linked to inflation, known as inflation-linked bonds or, in the U. But, unlike other bonds, inflation-linked bonds could experience greater losses when real interest rates are moving faster than nominal interest rates. Corporate bonds : After the government sector, corporate bonds have historically been the largest segment of the bond market. Corporations borrow money in the bond market to expand operations or fund new business ventures.

The corporate sector is evolving rapidly, particularly in Europe and many developing countries. Speculative-grade bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated, investment grade companies.

Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly. Speculative-grade bonds tend to be issued by newer companies, companies in particularly competitive or volatile sectors, or companies with troubling fundamentals. While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds aim to compensate investors for the higher risk.

Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. Emerging market bonds : Sovereign and corporate bonds issued by developing countries are also known as emerging market EM bonds. Diversification does not ensure a profit or protect against a loss. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

For more information about Vanguard funds, visit vanguard. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation. Advisory services are provided by Vanguard Advisers Inc. VAI , a registered investment advisor.

All rights reserved. Vanguard Marketing Corporation, Distributor. A bond's credit quality is usually determined by independent bond rating agencies, such as Moody's Investors Service, Inc. These agencies classify bonds into 2 basic categories—investment-grade and below-investment-grade—and provide detailed ratings within each.

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash. Rebecca Katz: All right, so our first question is actually from Kathy in Urbana, Illinois, and Kathy says, "My question is really a request. Would you please begin your discussion with an overview of muni bonds for those of us who have zero experience with them? Daniel Wallick: Sure. So, you can think of them as a contract between a local or state government and people that lend them money.

And what state and local governments are trying to do typically is fund capital projects, and what we mean by capital projects are projects that take a lot of money, a lot of capital. And so that could be a road, or that could be a school, or that could be a hospital, or that could be an electric system, or that could be a sewer. It could be any one of a number of things that just takes a lot of money. So what governments do, is they go out and borrow that money, pay for it up front to fund the project, and then repay that over a long period of time.

Rebecca Katz: Okay, and I did mention that there's some tax advantages to munis. Want to touch on that quickly? Daniel Wallick: Sure and so municipal bonds in particular since they affect state and local governments, they tend to have a tax advantage. So they're not subject to federal, state, or local taxes depending on the jurisdiction. And so there's this difference you'll see in the yields that accommodates for that difference in the tax impact.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax. We recommend that you consult a financial or tax advisor about your individual situation.

Rebecca Katz: Okay, great. Our next question is from—oh, it's a good follow-on question, from Steve in Columbus, Ohio. Thanks, Steve. How do they fit into your overall bond allocation? You know you need bonds for diversification and to minimize volatility.

How much muni versus taxable? Daniel Wallick: Right. A lot of this is going to drive off of a couple things. One, what's your risk tolerance. We talked earlier about the different types of bonds. Let's just talk about the three big buckets. You can have Treasuries, which are guaranteed by the U. You can have municipals, which are guaranteed by a state or local government, or you can have corporate bonds, which are guaranteed by some private company. The risk level is: the U. Treasuries are the most secure; munis are next; and then corporates are there.

So where are you in terms of that comfort level of how much risk you're willing to take? It's really the first question to ask. The second one is, "What's the yield on munis, what's your tax rate, and how does that relate to the other options you have, and is it a valuable investment based on that? Rebecca Katz: Right. I believe we have a chart we can show you on how to calculate what we call the "taxable-equivalent yield," correct? Chris Alwine: Yeah. If we could bring up that slide to go through it.

Now, it looks a little busy up there, but if you look at the top formula, the tax-equivalent yield equals your muni yield divided by one minus your tax rate. Your tax rate, though, is the combined tax rate. It would be your top marginal federal tax rate, as well as state, and then also the Affordable Care Act.

This is a new tax that was instituted in for investment earnings. Now, munis are exempt from that. What we did here is we took an example. A year A-rated muni today yields about 2. Someone in the top tax bracket would be paying 0. We divide that out, and we get 4. Now it's important to keep in mind when we're looking at tax-equivalent yields, we need to compare them to a similar alternative in taxable space.

Daniel brought up the different risk spectrums, so if we were to calculate the tax-equivalent yield of a high-yield muni to a Treasury security, that would not be a fair comparison. One has a lot more risk than the other. Now for the mathematically inclined, I will give a differing variation for that. It's not up on the screen, but your break-even tax rate would be one minus the muni yield divided by the taxable yield.

For those who want to manipulate the formula, who prefer to do algebra, it's out there to give it a try. But one minus the muni yield divided by the taxable yield gives you your break-even tax rate.

Well, we actually have a good follow-up question around break-evens, actually. This is from Timothy in New York, and he says, "Analyzing break-evens between taxable and tax-exempt bonds, does it make sense sometimes for someone not in the highest marginal tax rate to invest in munis?

Daniel Wallick: It can. One is, "What's the absolute level of muni yields? The other is, "What's your tax rate, your tax level? I will go back and just reiterate what Chris said. Learn all about government bonds: including what they are, how they work, and why they move in price. Interested in bods trading with IG?

Find out more. A government bond is a type of debt-based investment, where you loan money to a government in return for an agreed rate of interest. Governments use them to raise funds that can be spent on new projects or infrastructure, and investors can use them to get a set return paid at regular intervals. When you buy a government bond, you lend the government an agreed amount of money for an agreed period of time.

In return, the government will pay you back a set level of interest at regular periods, known as the coupon. This makes bonds a fixed-income asset. Once the bond expires, you'll get back to your original investment. The day on which you get your original investment back is called the maturity date. Different bonds will come with different maturity dates - you could buy a bond that matures in less than a year, or one that matures in 30 years or more.

The terminology surrounding bonds can make things appear much more complicated that they actually are. UK government bonds, for example, are referred to as gilts.

The maturity of each gilt is listed in the name, so a UK government bond that matures in two years is called a two-year gilt. In the US, meanwhile, bonds are referred to as treasuries. Treasuries come in three broad categories, according to their maturity:. Just like shares, government bonds can be held as an investment or sold on to other traders on the open market.

But their yield would be higher, because they paid less to get the same return. A bond with a price that is equal to its face value is said to be trading at par — if its price drops below par it is said to be trading at a discount , and if its price rises above par it is trading at a premium.

Just like any financial asset, government bond prices are dictated by supply and demand. Demand for bonds is dependent on whether the bond looks like an attractive investment. Interest rates can have a major impact on the demand for bonds. When the bond reaches maturity, you receive the face value, or the par value, of the bond.

If you sell the bond before maturity, what you get back depends on the prevailing interest rates. If interest rates have risen since the bond was purchased, the bondholder may have to sell at a discount below par. But if interest rates have fallen, the bondholder may be able to sell at a premium above par. Are you interested in a long-term investment? Use our CD rate calculator to compare bond rates with CD rates.

Each of these ways to invest in silver comes with its own risks and rewards. Your risk tolerance plays a crucial role in your game plan for growing your money. Certain windfalls are considered capital gains.