Government bond

A government bond, also called a sovereign bond, is a debt security issued by a national government to finance public spending. The bond typically promises to make regular interest payments, known as coupon payments, and to return the bond's face value to the investor when it matures. The current yield is calculated by dividing the annual interest payment by the bond's current market price. While a government's budget balance can affect market sentiment, bond yields are influenced by many factors—monetary policy, inflation expectations, and global demand—so there is no simple or consistent link between yield and budget balance. Government bonds may be issued in the government's own domestic currency or in a foreign currency. Economies that are less stable often issue bonds in a more stable foreign currency, sometimes called a hard currency. International credit rating agencies assign ratings to each country's bonds, and investors typically demand higher yields from bonds perceived as riskier. For instance, during the Greek government-debt crisis, the spread in yields between two-year and ten-year Greek and German government bonds reached 26,000 and 4,000 basis points, respectively. Governments nearing default are often described as being in a sovereign debt crisis.

One of the earliest instruments resembling government bonds was the forced loan, or *prestiti*, issued by the Republic of Venice in 1172 to fund wars and defense. These loans paid a nominal interest rate of 5% per year on the face value, distributed in two half-yearly payments, and could be sold on the open market for a lump sum. In 1694, William III of England used a syndicate of 1,268 investors to buy debt to finance the Nine Years' War; this syndicate received a Royal charter and became the Bank of England. Much of England's early government debt took unconventional forms, including annuities and lotteries, but alongside these were perpetual bonds with various coupon rates. By 1752, these perpetual bonds were consolidated (called consols) into a smaller number of distinct stocks with fixed coupon payments, giving the bond market a more modern shape. In the United States, government bonds date back to the American Revolution, when private citizens bought $27 million in government bonds to help fund the war. Today, the market for U.S. government bonds—known as U.S. Treasury securities—is the largest and most liquid government securities market globally, averaging $900 billion in daily transactions.

**Risks**

**Credit risk:** A government bond issued in its own currency is, strictly speaking, risk-free because the government can create additional currency to redeem the bond at maturity. However, some governments have chosen to default on domestic currency debt rather than print more money, as Russia did in 1998 during the ruble crisis. If a bond is issued in a foreign currency, the government cannot simply create that currency and must instead use its foreign currency reserves. Investors often rely on rating agencies to assess credit risk; in the United States, the Securities and Exchange Commission has designated ten agencies as nationally recognized statistical rating organizations.

**Currency risk:** Currency risk, or foreign exchange risk, is the exposure to exchange rate fluctuations for investors buying assets priced in a different currency. For example, a German investor would see U.S. bonds as having more currency risk than German bonds because the dollar might fall against the euro; conversely, a U.S. investor would view German bonds as riskier because the euro might weaken against the dollar. A bond paying in a currency with a history of losing value may not be a good deal, even if it offers a high interest rate.

**Inflation risk:** Inflation risk is the chance that an investor's real rate of return—after adjusting for inflation—turns negative. Inflation reduces the purchasing power of money. A fixed-rate bond is vulnerable to this: if a bond pays 5% interest but inflation is 4.5%, the real return is only 0.5%. Many governments issue inflation-indexed bonds, which protect investors by linking both interest and principal payments to a consumer price index. An example is U.S. Treasury Inflation-Protected Securities (TIPS).

**Interest rate risk:** Interest rate risk is the risk that a bond's price will fall due to changes in interest rates. Bond prices and interest rates move in opposite directions: when rates rise, bond prices drop. For instance, if an investor buys a ten-year $1,000 bond with a 3% coupon, and a year later interest rates rise to 4%, a new $1,000 bond would pay a 4% coupon. The original bond becomes less attractive to other investors unless it is sold at a discount.

**United Kingdom:** In the UK, government bonds are called gilts. Older issues are named "Treasury Stock," while newer ones are called "Treasury Gilt." There are two main types: conventional gilts, which have a fixed interest rate and maturity, and index-linked gilts, whose interest rate and principal are automatically adjusted for inflation.