What Is A Government Bond?
What is a Government Bond?
There are many types of bonds. In the study of finance, a bond is a type of debt security. It is a formal contract to repay a loaned or borrowed money with interest. One these types of bond is a government bond. A bond is like a loan in which the issuer is borrower, the holder of the bond is the lender and the coupon is the interest. A government bond follows this concept also.
In essence, a government bond is issued by a national government, the amount of which is denominated in that country's own currency. A government usually issues bonds to accumulate funds for a project or any governmental undertaking. This type of bonds usually come with face values of $1,000 or $10,000 or with a fixed amount under the currency of an issuing country.
When there's a government bond, there's what we call a coupon. The coupon is the interest rate the bond pays you - the interest rate being a fixed percentage of the face value of an issued government bond.
You will ask, how does a government bond work? A basic explanation is stated below from NB Canada Financial's site:
"A $1,000 bond with a 10% coupon will pay you $100 interest per year, usually in two semi- annual $50 payments. In most cases, you won't pay face value for a bond. You will either buy it at a discount or premium to face value. If you pay less than face value, you will make a profit when the bond matures at full face value. When added to the interest you will have received, this profit pushes up your return. This mix of interest and capital gain or loss is the bond's yield.
An attraction with bonds is that you don't have to wait until maturity to earn your full return. You can sell them in the bond market before they mature - and hopefully profit doing so. Whether you profit will mostly depend on what has happened to general interest rates since you bought the bond. If rates have come down, you will likely be able to sell the bond for more than you paid. If they've risen, however, you'll probably lose on the sale.
Say you pay face value for a $1,000, 10-year Government of Canada bond paying 10%. Two years later, you decide to sell when interest rates have dropped and similar bonds are yielding 8%. Instead of selling your bond for $1,000, you can sell it for more because it's 10% coupon is attractive. So you sell the bond for $1,085, giving you an $85 profit that pushes up your return to 14.25%. Eight years later, the person who bought the bond will get back its $1,000 face value, leaving a loss of $85. Spread out over the bond's remaining eight years, that loss reduces the buyer's return to about 8%.
Other factors besides interest rates can affect bond prices, such as the issuer's credit rating, the term to maturity, and the bond's coupon rate."