What is a Government Bond?

Governments at the federal, state and local levels all borrow funds to raise money for a variety of purposes. Most of this money is borrowed by issuing government bonds of several types. Government bonds pay a fixed rate and are issued for periods of time (maturities) of anywhere from a few weeks to 30 years (or even longer). Both individual and large institutional investors purchase government bonds to generate income with minimal risk and for the tax advantages most government ponds provide.

Identification

Government bonds can be divided into two categories. All state and local government bonds are grouped under the label "municipal bonds" (or "munis" for short). The federal government issues debt securities through the Department f the Treasury's Bureau of the Pubic Debt. Some government bonds (especially at the federal level) are issued only in large denominations of $10,000 and up and are bought by financial intuitions and bond funds. Individuals generally invest in these government bonds indirectly through shares in bond or money market funds. However, many government bonds are issued in $1000 and $5000 denominations and these are very popular with individual investors.

Tax Implications

Bond income, whether from corporate or government bonds, is considered regular income (no capital gains eligibility). However, US Treasury securities are exempt from all state and local taxes. Municipal bonds are exempt from federal income tax if the purpose of the bond meets federal criteria of being for the general public good. In addition, some states and localities exempt at least their own bonds from taxes. Municipal bonds subject to federal taxes may still be exempt from state/local taxes.

Treasury Securities

Treasury debt securities are generally categorized in terms of their maturity. The term Treasury bond is applied to bonds with maturities of 10 to 30 years. Treasury notes are bonds with maturities of 1 to 10 years. T-bills are bonds with maturities under one year (these are traded mainly in the money market, rather than in the bond market). Some bonds have special features. TIPS (Treasury Inflation Protected Securities) are indexed to the inflation rate. They pay lower interest, but at the end of each year, the face value of the bond is increased to offset inflation. Savings bonds are sold to individuals in denominations as low as $25, but at a discount. Interest accumulates until the bond matures, at which point it can be redeemed for its face value.

Municipal Bonds

Bonds issued by state and local governments are most often either general obligation or revenue bonds, depending on the source of funding to pay bond interest and principal. General obligation bonds are secured by the power of the issuing government to raise tax revenue. Revenue bonds depend on receipts generated by the project or facility they fund (such as a water system or toll road. Municipal bonds for purposes such as stadiums or assisting business development are revenue bonds, but are generally taxable since they don't meet federal criteria as a "pubic good" project.

Government Bond Funds

There are two types of mutual funds that invest in government bonds. Bond funds, like other mutual funds, use investor's money to maintain a portfolio of longer term government bonds (1 year maturity and up). Investors get the tax advantages, the safety of government bonds, and reasonably good income. These funds also provide the advantage of diversification, reducing risk still further. Some money market funds specialize in short-term T-Bills or municipal bonds. These bonds are not normally traded on the open market, so individuals usually can't invest in them directly. A money market bond fund that specializes in government bonds also passes along the tax advantages to the investor, which makes this type of money market fund very attractive to people in high tax brackets.