Government bonds allow federal, state and local governments to accomplish critical projects. Historically, these have been low-risk investments. However, government bonds carry interest rate risk and don't have the same earnings potential as higher-risk investments.
Bonds are financial instruments issued by a corporation or a government agency. Municipal bonds are issued by city and county governments for public works projects like schools, highways and hospitals. The federal government issues treasury bonds that mature between 10 and 30 years. Consumers also can purchase treasury inflation protected securities -- known as TIPS -- which are bonds that protect against inflation.
The biggest risk you face as a bondholder is that the agency that issued the bond will default on its obligation. If this happens, you won't continue to get coupon payments or the maturity payment for the bond. Compared to corporations, governments are a safer bet. It's rare that a local government will default on bonds and even more unlikely that the federal government will do so. In contrast, corporations can -- and do -- declare bankruptcy and default on obligations from time to time.
Some investors may like the idea of their funds going to support government projects rather than a faceless corporation, with their contributions funding efforts that are easy to see and understand. For municipal bonds in particular, bonds fund important efforts that improve the local community and create jobs. This makes purchasing municipal bonds an attractive option for investors who want funds to stay in their state or local community.
With most bonds, you're subject to state and federal income tax on interest income you receive from bond coupons. However, bonds issued by a state are exempt from federal taxes and, in some cases, exempt from state taxes as well. Some U.S. savings bonds also are exempt from federal tax. This can be a sizable savings -- for example, a taxpayer with $4,000 of interest in the 25 percent tax bracket can save $1,000 investing in a municipal bond instead of a taxable investment.
Lower Rate of Return
When it comes to investing, risk and rate of return have an inverse relationship. Because the risk of default is so low, the yield rate on government bonds currently caps out at around 3 or 3.5 percent. If the bond isn't an inflation-protected security, it's possible that it won't even beat the rate of inflation. In contrast, the historical return on investing in the stock market is much higher.
Interest Rate Risk
When you purchase a bond, you're locking in an interest rate for 10, 20 or even 30 years. That means that if interest rates suddenly rise dramatically, you're stuck with an investment that's paying an interest rate below market value. In turn, this decreases the market value of your bond. This may not matter if you hold the bond to maturity -- since you'll receive the par value when it matures -- but it means the bond won't go for much if you try to sell it before maturity on a bond market.