 Personal Finance Powerpoint Presentation Government Bond. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Government Bond, which you can find online. Take a look at the references, resources, continue your research from there. This is by James Chin, updated November 29, 2020. In prior presentations, we've been looking at our investment goals, our investment strategies, investment tools, keeping that in context. We're now considering what is a government bond? A government bond is a debt security issued by a government to support government spending and obligations. Government bonds can pay periodic interest payments called coupon payments. So when we're thinking about investments, we often categorize in terms of bonds and stocks, possibly thinking about stocks first and then the investment in bonds. Typically when we're thinking about diversification and asset allocation, we might want some mix between assets and bonds. One of the most common types of bonds and safe types of bonds would be the government bonds. So government bonds issued by national governments are often considered low risk investments since the issue in government backs them. So in other words, when you invest in bonds as opposed to the stocks, you're going to be setting down the terms upfront, which would be that how long are the bonds going to be lasting, how much rate of return, how much interest am I going to be receiving on it? And if you were to say, have a company, if the company was to go bankrupt, for example, you would typically get paid through the bankruptcy, through the liquidation process before the stockholders giving you a little bit of a safeguard in that event. However, on the plus side, if you were investing in company bonds, you don't have as much exposure to the plus side where you might have increase in the value of dividends that might be going out to shareholders and increase in basically the value of the stocks. When you're looking at the government bonds, they're issued by the government, so you hopefully don't have that same kind of problem of the government going under, the government going bankrupt, the government not paying their bonds. If the government doesn't pay their bonds, especially if they were US bonds, government bonds, that would be a big major issue. So therefore, they're considered basically low risk investment. Government bonds may also be known as sovereign debt. Government bonds explained government bonds are issued by governments to raise money to finance projects or day to day operations. The US Treasury Department sells the issued bonds during auction through the year. Some treasury bonds trade in the secondary market. Individual investors working with a financial institution or broker can buy and sell previously issued bonds through this market. So in other words, when they issue the bond from the actual government itself, that's going into the market. You can also have the secondary market, which is purchasing and selling bonds that have already been issued from other investors as opposed to purchasing from the government, the original issuer itself. Treasuries are widely available for purchase through the US Treasury, brokers as well as exchange traded funds, which contain a basket of securities. So we can once again think about how we're going to have our allocation mix possibly thrown in the bonds into that mix. So fixed rate government bonds can have interest rate risk, which occurs when interest rates are rising and investors are holding lower paying fixed rate bonds as compared to the market. So when you have your money in bonds, then the issue is going to be, okay, if I have my underlying investment in these bonds that has an end term to it and a fixed interest rate, that can be good because it gives me some security and if the market rates then go down, well, I'm tied into this fixed interest rate, that could be good. But if market rates goes up and I'm tied into this fixed interest rate on the bond, that could be bad because if I didn't have my money invested in the bonds, I might be able to purchase other assets that would have a higher return would be the general idea. Also, only select bonds keep up with inflation, which is a major of price increases throughout the economy. If a fixed rate government bond pays 2% per year, for example, and prices in the economy rise by 1.5%, the investor is only earning 5% in real terms. So notice when you think about bonds, they tend to be a little bit more boring, right? Because you've got the fixed rate of return. It is what it is. You're not following the drama of the market. The increases and decreases as closely. And again, there's pros and cons to that. So we also have to consider basically what's going to be, you know, the inflation factor that's going to be in place to consider what the real returns we are receiving are. Local governments may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as municipal bonds and often carry certain tax advantages for investors, possibly having some tax benefits. So it's not going to be included in taxable income. If it's not included in taxable income, then you basically got your rate of return, a more beneficial rate of return because it's not going to be, the government's not going to be taking part of it would be the general idea. The U.S. versus foreign government bonds, U.S. treasuries are nearly as close to risk-free and investments can get. So when we're thinking about how can I invest in something that's going to have the lowest amount of risk, then typically you're thinking U.S. bonds because again, they're backed by the U.S. government, which you're hoping is going to be the most stable thing, possibly the most stable kind of government in the world, you would think or would be generally thought at this point. So this low risk profile is because the issuing government backs the bond. Government bonds from the U.S. Treasury are some of the most secured worldwide while those floated by other countries may carry a greater degree of risk. So clearly bonds by other countries might have more risk because just like when you're talking about companies that might have more risk to basically go bankrupt or default on the bonds or not pay the bonds, you would think that other countries that might not be as secure might have similar risks. So due to this nearly risk-free nature, market participants and analysts use treasuries as a benchmark in comparing the risk associated with securities. The 10-year treasury bond is also used as a benchmark and guide for interest rates on lending products. Due to their low risk, U.S. treasuries tend to offer lower rates of return related to equities and corporate bonds. So clearly the fact that you have the low risk there means that the government can issue the bonds with lower rates of return because those things are correlated, right? So if I can have a lower guaranteed return, I'm willing to have lesser of a return than if I was to park my money elsewhere, keeping that in mind and in conjunction with my overall diversification strategy and investment strategy. However, government-backed bonds, particularly those in emergency markets, can carry risks that include country risk, political risk, and central bank risk, including whether the banking system is solvent. Investors saw a bleak reminder of how risky some government bonds can be during the Asian financial crisis of 1997 and 1998. During this crisis, several Asian nations were forced to devalue their currency, which sent reverberations around the world. The crisis even caused Russia default on its debt. So again, it's a huge thing if there's a default on the bonds. If you see that on a corporation side of things as well, similar kind of thing. If you've made a promise to pay the bonds and basically you're not paying the bonds, then people's assurance goes way down and once people no longer have any confidence in the investment, that usually leads to a spiral effect on the downturn. Countries can have a similar kind of thing and obviously that's something that countries would want to avoid by maintaining trust in the systems and their ability to pay their obligations. So the uses of government bonds. Government bonds assist in funding deficits in the federal budget and are used to raise capital for various projects such as infrastructure spending. However, government bonds are also used by Federal Reserve Bank to control the nation's money supply. So you might think, well, why does the government need, you know, need to issue the bonds? Well, there's multiple factors on issuing the bonds. They're going to make their money. The government or, you know, gets money at least through taxation generally, but they can also basically take on, you know, debt by issuing the bonds and the bonds can also be used for manipulation of the money supplied by the Federal Reserve to try to keep the market moving in the rate of growth that they would like without overheating or hitting recession and we'll see what their track record looks like at that from this point forward. It's an interesting time to see what their track record is going to do in the time ahead as according to this recording. When the Federal Reserve repurchases US government bonds, the money supply increases throughout the economy as sellers receive funds to spend or invest in the market. So in other words, once the bonds have already been issued and are being held by private investors, the government itself, the Federal Reserve in an attempt to manage the money supply and the economy may repurchase those government bonds as they do so, they're going to be paying money to the investors in the market, putting more money into the market which they're hoping will flow within the market and stimulate basically the economy in accordance to whatever plan they're currently putting over in place at the Federal Reserve to get things going. So any funds deposits into the bank are in turn used by those financial institutions to loan to companies and individuals further boosting economic activity. So if the funds then go to the bank, the idea of the bank holding on funds is that they can then loan those funds out to investors who can then invest into the economy once again, stimulating the economy would be the idea. Pros and cons of government bonds. As with all investments, government bonds provide both benefits and disadvantages to the bond holder. On the upside, these debt securities tend to return a steady stream of interest income. So that's going to be the point we're going to say, I got a steady income that I can depend on because I've basically laid down the terms of the government bond. The maturity date, the amount of interest is going to be what it is. However, this return is usually lower than other products on the market due to the reduced level of risk involved in their investment. So clearly, if it's a guaranteed return, then the government can issue those bonds at a low rate of return. And if you're comparing the rate of return there to other types of investments that you could potentially have, typically to equity or stock investments, it usually looks not great, right? So that's why you're going to use it generally as part of your investment strategy, as part of your diversification asset allocation. The market for U.S. government bonds is very liquid, allowing the holder to resell them on the secondary bond market easily. So when you have the bond, then the question is, are you able to then remove yourself from that position if you need then the money for some other reason? Like with many stock type of investments, if it's not under the umbrella of an IRA or a 401k plan, then you can usually sell the bond on the secondary market. Now you're the seller of the bond that was issued by, say, the government. And you can usually do so and liquidate it in a reasonable amount of time for any needs that you have. So there are even ETFs and mutual funds that focus their investment on treasury bonds. So you might then, as part of your investment strategy, to try to get exposure to bonds, use a mutual fund or ETF kind of strategy in that way as well. So fixed rate bonds may fall behind during periods of increasing inflation or rising market interest rates. Also, foreign bonds are exposed to sovereign or governmental risk changes in currency rates and have a higher risk of default. Some U.S. treasury bonds are free of state and federal taxes. So another tax benefit is one of the reasons that you can get access to them as well. But again, the tax benefit that you get, you would think given the market is transparent would be in the market price. So if you get a tax benefit on it, you would think that there's gonna be a lower return on the bonds given the fact that these things are probably factored in to the whole equation. But the investor of foreign bonds may face taxes on income from these foreign investments. So what are the pros? Pay a steady interest income return. Low risk of default for U.S. bonds exempt from state and local taxes. A liquid market for reselling accessible through mutual funds and ETFs. What are the cons? Offer low rates of return. So there's the trade-off between a guaranteed return. Anything that's guaranteed is usually gonna is not gonna give you as much of a return. You would think that if it's not a guaranteed thing. Fixed income falls behind with raising rising inflation. A carried risk when market interest rates increase default and other risks on foreign bonds. So real-world example of U.S. Treasury bonds. Let's take a look at it. There are various types of bonds offered by the U.S. Treasury that have various maturities. In addition, some bonds return regular interest payments. Well, some do not. Savings bonds. The U.S. Treasury offers Series EE bonds and Series ISavings bonds. Bonds sell at face value and have a fixed rate of return. Bonds held for 20 years will reach their face value and effectively double Series I bonds receive a semi-annual calculated secondary rate tied to an inflation rate. So in other words, when you think about the bonds typically you're gonna have the issuance of bonds. You've got the maturity date of the bonds and then you're gonna think about how the interest rate is going to be paid. Are they gonna be paying you interest periodically and or at the termination of the bond at the end of the maturity date of the bond? Then you have the payout which is gonna be the face value in essence of the bond. So once again, let's take a look at that. The U.S. Treasury offers Series EE bonds and Series I savings bonds. Bonds sell at face value and have a fixed rate of return. Bonds held for 20 years will reach their face value and effectively double Series I bonds receive a semi-annual calculated secondary rate tied to an inflation rate. So that's where you're gonna... So the second one you get like an income stream kind of with the semi-annual items. Treasury notes. Treasury notes, T-notes are intermediate term bonds maturing in 2, 3, 5 or 10 years that provide fixed coupon returns. T-notes typically have a $1,000 face value. So they typically, when you're buying them, are multiples of the face value of the 1,000, the 1,000. Then face value is what you usually receive at the end or maturity date of the bond. So however, two or three year maturities have a $5,000 face value. Although yields change daily, the 10 year yield closed at 2.406% March 31st, 2019. And at that time had a 52 week range of 2.341% to 3.263%. Treasury Inflation Protected Securities. These are the tips. Treasury Inflation Protected Securities tips is a Treasury Security Index to Inflation. They protect investors from the adverse effects of rising prices. So now you're trying to say, well, what if there's a risk of prices going up? Is there a way that I can basically hedge for that or deal with that? You might then say, is there a way that I can have the securities kind of adjust for that event? So the power value principle increases with inflation and decreases with deflation following the consumer price index. So that's great. But again, the fact that you now have this safeguard against that particular risk, you would think would have been factored into the market and factored into the price of the bonds. Tips pay a fixed rate interest-determined on the bond's auction on a six-month basis. However, interest payment amounts very since the rate applies to the adjusted principle value of the bond. Tips have maturities of 5, 10, and 30 years. On November 19, 2020, the 10-year tips bond was auctioned with an interest rate of negative 0.867%.