Government Bonds Essay

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A government bond is a security issue by the national government of a particular country that gives the right to the bearer to request the promised interest to be paid in agreed intervals (usually annually). This is a special type of bond, based on the qualities of the issuer. It is like any other “I owe you” (IOU) instrument, but the only specific is that the issuer is the national government, or an authorized agent on behalf of the national government.

National governments issues bonds in order to finance shortfalls in their budgets, and as the level of sovereign debt is growing worldwide, government securities in general, and government bonds in particular, are becoming an increasingly interesting form of investment. As these instruments are, theoretically, highly liquid, they can be used (although they are medium and long-term instruments) for liquidity management by various economic subjects. As in the case of bonds issued by private companies (nonstate entities) they represent a promise to pay the holder a set level of interest (known as the coupon) during the lifetime of the bond and to repay the money in full on a set date.

This is the general rule, although it is possible to issue a perpetual bond, whose principal will never be repaid, but the government will service them. This is, for instance, the case with consols in the United Kingdom (UK). They are a rare living example of perpetuity in bond issuance, although technically speaking an issuer has an option to redeem them. They have been particularly popular in financing military conflict in the past and there are still some live consols that were issued in order for the UK government to raise funds to finance Napoleonic wars.

Government bonds are, as a rule, denominated in domestic currency and are often referred to as sovereign bonds. A national government is a sovereign power and therefore the bonds have those qualities as well. Government bonds are regarded, in theory, as risk-free bonds, assuming there is a very low or no probability that the national government will default and go bankrupt. Although economists may claim that every economic agent (including the national government) is prone to bankruptcy if insolvent, the legal theorists would (rightly) state that the government can always resort to the unpopular and somewhat immoral option of nationalization and confiscation in order to meet its financial obligations. Most recently, Russia, following the 1998 crisis, declared a moratorium on debt servicing, but the servicing of the public debt resumed after a short while.

Government bonds are regarded as virtually riskless, but one should know that this is only in relation to the credit risk—namely, the risk that the credit will not be returned. All other risks are still present and largely are shared with all other types of bonds, regardless of an issuer, such as foreign exchange, operational, and so on. Government bonds, like other bonds, are also rated by rating agencies, and despite the perception of their stability and inability to go bankrupt, their ratings differ. Only the most advanced industrialized nations have a “triple A” rating, while for instance Japan and Italy (although members of the G7 group of countries) have ratings below the maximum one.

Government bonds being literally default free may be more attractive, especially if the investment is not made at the peak of an interest rate cycle, in which case there is a clear opportunity for capital gain. If the investment is made at the peak of the interest rate boom, then when the interest rate falls, the value of the bond will be reduced and can go well beyond the nominal value. Bonds being fixed-income financial instruments are highly dependent on the (current, market) interest rate, and their market value is linked with the level of interest rates applied. A rise in the price of a bond means a fall in the interest rate, while the reverse applies when the price falls.

Often the issuance of government bonds is centralized at the national level, although often local governments may be empowered by law to raise needed finances in the financial markets. Most recently the debt management function was entrusted to a government agency that would issue securities on behalf of the national government and its finance department/ministry. For instance, in the UK the Debt Management Agency is authorized by law to issue government securities (bonds, or “gilts”) and manage servicing of the outstanding stock.

There are also other modalities present. In some countries the central bank, as a fiscal agent of the government, may be authorized to issue bonds, that is, the government securities, while in others the Ministry of Finance may be in charge of issuing securities for the national government. However, as we have already pointed out, the current trend is to organize a separate government agency where the professionals will be entrusted with the task of managing public debt, free from day-to-day political pressures. However, the practice has shown that independence from daily politics is very difficult to sustain.

The importance of government bonds will grow, especially as traditionally debt-averse governments are looking into the issue of public debt, as it is becoming increasingly difficult to finance needs with the budgetary inflows, and monetization of public debt has devastating consequences on economic development and economic and financial stability.

Bibliography:

  1. José Manuel Amor, ed., Government Bond Market in the Euro Zone (John Wiley & Sons, 2002);
  2. M. Coombs and D. E. Jenkins, Public Sector Financial Management, 2nd ed. (International Thomson Business Press, 1994);
  3. Coyle, Government Bonds, rev. ed. (Financial World Publishing, 2004);
  4. “Economic and Financial Indicators: Statistics on 43 Economies, Plus Closer Looks at Foreign Direct Investment and Government Bonds,” Economist (v.382/8512, 2007);
  5. Esme Faerber, All About Bonds, Bond Mutual Funds, and Bond Exchange Traded Funds (McGraw-Hill, 2009).

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