Government bonds provide a means for investors to lend money to governments in exchange for interest payments. Typically, a government bond pays fixed payments or ‘coupons’ to the holder every 6 months. At a fixed redemption date, the original capital is repaid.
Investors and pension holders frequently access government bonds by investing in funds.
While developing countries also issue bonds, this page refers primarily to bonds issued by developed European countries.
Advantages of government bonds
Government bonds have the following advantages:
- Risk is usually relatively low compared to equities, as interest and principal will be repaid provided the relevant governments do not default on their bonds.
- Bonds can be an excellent diversifier, as they frequently perform well when other asset classes perform badly.
- Bonds are liquid and early redemption is easy, as bonds are bought and sold on the open market every day.
Disadvantages of government bonds
Government Bonds have the following disadvantages:
- The interest paid on bonds or the ‘yield’ can be low.
- Bonds can lose value on the open market if interest rate or inflation expectations rise. This is because higher interest rates or higher inflation make the fixed interest paid by bonds less attractive.
- Long run returns tend to be lower than for riskier assets such as equities and property. However, bond returns tend to exceed cash deposits over long periods.
- Bonds can be vulnerable if the government that issues them enters a fiscal crisis that raises doubts about whether debt obligations will be honoured.
Role of government bonds in a portfolio
For many of the investment strategies that we recommend to our clients, the main role of government bonds is as a diversifier in low-medium risk or medium risk portfolios. Because government bond values tend not to move in line with equity values, they can help to reduce volatility in a portfolio significantly.
Government bonds may also prove useful for those who plan to use their pension fund to buy a guaranteed income for life, or ‘annuity’. The price of an annuity is linked to the price of government bonds. Thus, when a pension fund holder nears retirement age, by purchasing bonds they can provide a good means of protecting its value for annuity purchase purposes.