Risks of Government Bonds
Government bonds are debt securities issued by the U.S. Treasury Department or other government or federally sponsored enterprises. There are different types of debt securities issued by these entities. U.S. government debt is considered to be the safest investment in the world, but there are still risks involved in owning these securities.
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The Treasury
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The U.S. Treasury issues several forms of investment securities. Treasury Bills have maturities up to 52 weeks and are sold at a discount to the face value. Treasury Notes are issued with maturities from two to 10 years and pay interest every six months. Treasury Bonds are issued with 30-year maturities and semi-annual interest payments. Treasury Inflation-Protection Securities, or TIPS are issued with maturities of five, 10 or 20 years and pay interest every six months. TIPS also have their principal value adjusted twice a year in line with inflation.
Government Sponsored Entitities
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There are several agencies that issue securities with explicit or implied U.S. government backing. Some of the prominent players are the Federal Home Loan Banks, Fannie Mae, Freddie Mac and the Federal Farm Credit Banks. These agencies usually issue mortgage-backed securities funded by pools of government insured loans.
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Risks
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The risks associated with bond investing are credit risk, interest rate risk and purchasing power risk. Credit risk is the possibility the bond issuer will not be able to pay interest or principal. U.S. government bonds are rated AAA and are considered free of credit risk. Interest rate risk involves the chance that prevailing interest rates will go higher than the coupon rate of the bond(s) currently owned. Purchasing power risk is the possibility that inflation will erode the purchasing power of invested money faster than interest is earned.
Considerations
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Interest rate risk can be positive or negative for bond investors. The market adjusts for changes in interest rates by changing the market value of bonds based on their interest or coupon rate and time to maturity. If interest rates increase, the market value of bonds will fall to allow buyers to earn a competitive return. When interest rates are falling, market values of bonds will increase. Bonds with a greater time until maturity will have a larger price change than short maturities. Bond traders and investors want to buy longer maturity bonds in a falling rate environment and short-term securities in a rising rate environment.
Inflation
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The risk free interest rate paid by government bonds is roughly parallel to the current inflation rate. Inflation reduces the purchasing power of the bond principal. TIPS provide bondholders with increasing principal value to offset inflation. TIPS will pay lower semi-annual interest than bonds without inflation protection.
Mortgage Backed
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Mortgage backed securities (MBS) have a different risk in relation to changing interest rates. MBS holders will receive payments every month as mortgages in the pool receive their payments. Payments are a combination of principal and interest. If interest rates decline, the mortgages in the pool will be refinanced and the bond holder will have their principal refunded faster than planned. The principal will have to be reinvested at the current lower interest rates.
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