What is a government bond?
A government bond is a form of security sold by the government. It is called a fixed income security because it earns a fixed amount of interest every year for the duration of the bond. The purpose of a government bond is to raise money to operate the government and to pay down debt.
Government bonds are considered to be secure. That is, it is very unlikely that the government will default. Bonds have maturity dates that may vary from one month to 30 years.
Government bonds may be issued by the federal government or one of its agencies. Bonds issued by local government agencies are called municipal bonds and are not considered as secure as U.S government bonds.
There are four categories of U.S. Treasury securities:
- Treasury bills are bonds that mature in less than one year.
- Treasury notes have a maturity date between one and 10 years.
- Treasury bonds are longer-term bonds, with a maturity date that’s more than 10 years.
- Treasury inflation protected security, or TIPS, is a slightly different form of government bond. It has an interest rate adjusted semiannually in line with inflation.
Government bonds can be freely traded, and the price at which they trade is related to the interest rate of the bond, its remaining life and the current rate of interest on new bonds.
Interest earned from government bonds is only taxed at a federal level and not at a state level. By comparison, interest on municipal bonds is free of both federal and state tax, provided the investor lives in the state or municipality that issued the bond.
Government bond example
If you buy a government bond, you buy it for less than face value. When the bond reaches maturity, you receive the face value, or the par value, of the bond.
Treasury bills don’t pay coupon interest, but Treasury bonds and notes do on a semiannual basis.
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.
You may have to pay a commission for the transaction or your broker may take a “markdown.” A markdown is an amount, usually a percentage, by which your broker reduces the sales price to cover the cost of the transaction and make a profit on it.
Are you interested in a long-term investment? Use our CD rate calculator to compare bond rates with CD rates.