Government bonds are simply bonds issued by the national government and its denomination is of course in the currency of the country where it was issued. Like in the U.S., government bonds are issued by the U.S. Treasury in the value of US dollars while other countries use their own denomination. But aside from this simple definition of what government bonds are, there are other factors on why it is rated as the highest of all bonds and why it yield the lowest risk.
The Risks in Government Bonds
The first known government bonds were issued in 1963 by the English government to raise its fund for the war against France. Since then, many other countries soon followed suit. Now, government bonds are the preferred investment since it is deemed as the lowest risk or it involves very little risk. The main reason for this is that it is backed up by the credit and taxing power of its country issuer. Like in the U.S., the government guaranteed the government bonds in ‘full faith and credit’ and again, it is because of the taxing power of the country.
Literature on economics would also state that government bonds are rather risk-free bonds; and since the money for the sale of the government bonds are used to finance federal projects, the country issuer has the power to raise its taxes to redeem the bonds at its maturity. However, the risk-free factor of government bonds only refers to the credit risk while inflation and currency risks still affect the value of government bonds.
Inflation Rates and Currency Risk Affects Government Bonds
Inflation affects the value of government bonds. Let’s say when you buy government bonds that pays a low interest like 3% but the inflation rate climbs to 4%, then you will be losing money. The value of the government bonds from the time you bought it is higher than its current value because of inflation. However, you can gain back the amount you originally invested in your government bonds when it reached its maturity.
Still, the U.S. Treasury has a vehicle to ensure safety of its investors against inflation rates. In 1997, the U.S. Treasury introduced the Treasury Inflation-Protected Securities (TIPS) that guarantees a fixed-income investment. With TIPS, you can let go of your worries. Your government bonds with TIPS security will not be affected with the increasing inflation rates.
More so, as the Consumer Price Index (CPI) rises, your principal investments will be adjusted favorably but if the CPI declines, then your investment will still bear the same value at the time you bought it; investment with TIPS security will be paid in face value upon its maturity.
An investor can buy TIPS either directly at the Treasury Department or through investment banks and other financial institutions, brokers and investment advisers. However, you can take full advantage of TIPS if you buy it from the Treasury Department—free of fees and no commissions will be deducted.
Even so, the sales of TIPS at the Treasury Department are only available on a particular month. If an investor failed to buy TIPS on the specified month for its issuance, then you will have to buy it from the brokers, banks, etc.; it is when you need to pay commissions and fees. But on the lighter side, you still have options to choose the broker or banks that require less fees and commissions.
Currency risk, on the other hand, is a risk taken by foreign investors. Like when a non-U.S. investor invests in U.S. government bonds but because of inflation the value of the US dollars declined as compared to other currencies. It is then that the investor losses money. But generally, a non-citizen investor will likely choose a stable currency to invest in. And just like investing in stocks, there are indicators that could help a foreign investor to gauge the stability of a given currency.