Have you ever wondered why only a few people have actually benefited from their investment in the bond sector despite the huge potential that these bonds offered? From statistics, the interest gain by most investors for several years has just been a percentage or two. Investing is easy, but investing in the right bonds and the right ways had never been easy for many for many reasons. Some people just invest because they have the money, to some it’s fun, but a few who know what investing means, they do it for business. If you are investing to make money, then you have to consider many aspects before putting your money on the line. For you have to understand the types of bonds to invest in, when to buy the bonds, how long it takes to reach maturity, how is the interest rate calculated, and all the legal aspects governing the buying and selling of the bond.
In a bid to help many come out of their limitations, we have come up with this article, putting together, how government bonds works and the best ways to invest in government bonds. While the government bonds open the way for investors to make a good return on their investment, each investor must consider several aspects of the economy of the country such as inflation, country financial stability, and political stability before investing in government bonds.
What is a Government Bond?
In order to understand what a bond is, let’s look at this example. Consider the situation where the U.S. government has a huge project in hand (such as building a new nuclear station) but in the government treasury there is no money to cover the expenditure. In order for the government to raise the needed amount of money, it has to borrow from the public. But the government cannot come to individuals to ask for such amount so what it does is to sell-out any debt security it has. A debt security will simply mean the government putting off some amount of money for the public to buy and interest paid for it to the investors after a given duration, known as the maturity period. The government assumes that after such long period, it would have recovered the amount of money sold out together with the needed interest to pay off its debt.
How government bonds work?
The first fact to understand about government bonds is that these securities are backed by the trust of the government and the government is not less, likely to disappoint or go back on its words like individuals or some local society. For this reason, investing in government bonds is said to be a supper safe type of investment.
There are about six different types of government bonds that are available to investors. These bonds on most part are different in their maturity period and the interest rate otherwise known as the government bond yields. These consist of:
Treasury notes: These types of government bonds have the ability to mature on different durations. They have a 2, 3, 5, or 10 year maturity period. If you plan to invest in this type of bonds, you have to choose which to get depending on the duration you can wait for your investment to mature.
Treasury bills: These types of government bonds have a maximum of one year maturity period.
Treasury bonds: These types of government bonds become mature only after a period of 10 years.
Treasury Inflation-Protected Securities (TIPS): These types of government bonds are typically long-term investment bonds.
Savings Bonds: There are two basic types of government savings bonds, the Series EE Savings Bonds and the Series I Savings Bonds. These types of government bonds are usually traded on a long term basis, it usually takes 20 years to reach maturity. However, they also offer the best interest rates if you can actually wait till maturity.
Government bond yields are usually calculated at a fixed rate of interest for which reason they are often referred to as fixed-income securities. The issuer (a corporation or government) agrees to pay a fixed rate of interest for the entire duration of the bond. This simply means that, although the interest rate in the market may change during the life of your bond, the interest rate paid on your bond will still be those stated at the time of purchased.
For example, if you bought a $1000 worth of bonds at 5% interest rates some 10 years ago and at maturity, the current interest rate has fallen to 3%, your bond will still pay at 5% interest rate. This may sound a worthy investment for you as you will be able to make a good return on your investment. On the other hand, consider that at the moment of maturity, interest rate has risen to 8%. Your bonds will still be calculated on the 5% interest rates, same rate at the time you bought the bonds. In such a scenario, it may sound like you made the wrong investment. You still make some money on your initial investment.
You may agree with me at this stage that the big question to answer before getting into investing in government bond is “what will the rates be at the time of maturity?” If you believe the rates will be higher next year, you may choose to wait until next year to invest in bonds. On the other hand, if you think this year’s rates are the best, you have to run them to the Treasury Direct website to get for yourself a good portion of the government bonds before they run out of stock.
So, how government bonds work?
Assuming the government need $5,000,000,000 to complete the new nuclear project. It will ask the Treasury to sell-out bonds worth this amount ($5,000,000,000) and based on the current interest rate, say 5%. The treasury on its part will advertise this amount as bonds on its (Treasury Direct) website. Once an individual or organization meet the eligibility criteria, he goes to this website and purchase the fraction they are able to buy. This will go on until the government will be able to raise the total amount needed for its project.
If these bonds were sold out base on a 10 year maturity period, then after the said period, the government pays the treasury the $5,000,000,000 and the 5% of 5,000,000,000 ($250,000,000) each year. For the period of 10 years, the interest sum up to $2,500,000,000. Therefore, the government has to put back into its Treasury the sum of 7,500,000,000 ($5,000,000,000 + $2,500,000,000). This sum is then share to all those who invested in the original sum.
For example, if you bought $10,000 worth of these bonds some ten years ago, you will receive $500 (5% of 10,000) interest each year. Therefore, for the 10 year period your interest will be $5,000 ($500*10). You receive your investment and the interest at maturity. Thus, you receive $15,000 ($10,000 + $5,000).
You will receive this amount only when you hold the bond until its maturity date. If, however, you intern to redeem your bonds before their maturity date, you will however, in some instances, be required to pay a fine on your amount and your interest may not be calculated on the 5% rate. You may end up with a 1% interest rate or even lower. This is the most reason; you have to hold on to your investment until its maturity date to able to reap the fruits of your investment.
If you are planning on investing in government bonds, you have to plan with respect to their maturity dates. If you can’t wait for 20 good years (savings bonds), it’s more preferable to invest in shorter maturity bonds like the treasury notes. However, if you can wait until the maturity date of the bonds, then the Treasury Direct website is the best place to go for your investment. If however you can’t wait, this site may prove very disadvantageous to you. You may have to go to other financial institutions such as the banks or brokers for your investment. It is very much difficult to sell bonds on Treasury Direct that have not yet reached maturity, but very easy for bonds that has stayed until their maturity date.
Using the Treasury Direct Website
This website is the U.S Government only approved website that allows you the ability to buy and redeem bonds electronically, directly from the U.S. Department of Treasury. The best government bonds are traded only on this site and electronically too. Once you meet the various criteria to trade in the U.S. Government bonds, you can go to this website and trade directly with the U.S. Government. However, you should be able to wait until the maturity of your bonds before you can redeem it. If you decide to redeem it before the said maturity date, you will not only find it very difficult, you may actually redeem it at a lost. Also, you will be able to invest only in new bonds. Thus, if you are looking to invest in secondary bonds (older bonds), Treasury Direct is not for you. You may check other brokers and corporations for such deals.
Who can invest in Government Bonds?
In order to be able to trade in the U.S. Government bonds, you are required to meet certain eligibility criteria. These criteria include:
- · You must be a U.S. citizen
- · Be a member of a private or public organization, corporation, association or fiduciaries
- · You must be a resident of the U.S. However, U.S. citizens living abroad must have a recorded U.S. address
- · A minor, and civilian employee of the U.S. (no matter their residence)
Once you are eligible, you should go directly to the Treasury Direct website and sign up your account. You will be asked to fill out a form. Amongst the many information needed, you will have to provide your name, address, social security number, contact (email and telephone) and your bank account. Remember that you will only be able to trade electronically on the Treasury website. Thus, your bank account will be required to be able to transfer funds directly into the government account electronically and also at the time of redeeming you bonds, to easily transfer funds electronically from the government account into your bank account.
The process of signing up your trading account is relatively easy, taking between 10 to 15 minutes only. After which, you can be rest assure you money is in safe investments, backed by the full faith of the U.S. Government.
The Treasury Direct website also allows for the possibility to invest in bonds using a Payroll Saving Plan. This plan allows investors to buy bonds through their companies. Once sign up for a payroll saving plan, you allow your employer to automatically purchase bonds electronically at the end of every month on your behalf. The amount agreed is automatically withdrawn from your pay package and send to an account at the Treasury Direct and the equivalent amount of bonds is credited to your account.
Know the Government Bond Yields
Just as important as what type of government bonds to invest in, is what the government bond yields are. You must know the various government bond yields or interest rate or what others refer to as the credit rating on the bond. The question here is “will the bond issuer be able to pay or deliver on the promise?” All bonds are weighted based on the potential of the issuer to pay the initial investment amount and the interest on this amount. Higher rated bonds are equally the most expensive. This is to say, bonds with the lowest risk usually have the lowest interest rate and those with high risk have also a higher interest rate. This is to say, the interest rate act as compensation for the risk the investors have to bear while investing in his chosen type of bond. This is the only way issuers can attract investor to poor rating bonds by issuing higher interest rates.
Diversify your investment
One of the best ways to invest in government bonds is to diversify your investment. How? Instead of putting all your investment in buying a single bond type, it is better to use it in buying different types of bonds. This may also mean investing in government bonds from different providers or investing in different bonds from the same provider, investing in bonds with different maturity dates, and bonds from different countries. This type of investment reduces or eliminates what is known as a risk due to changes in the markets and industries or non-systemic risk. When you invest in bonds with varying credit ratings, you balance some of the risk of poorly rated bonds. If you buy bonds that have different duration to maturity, say 2 years (short-term) and 10 years (long-term) maturity, you may benefit from their different performance levels. However, you will equally have some funds to back you up while you wait for the long-term bonds to reach maturity. You may also decide to go for an ETF. Remember that the Treasury Direct website also allows you the possibility to diversify your investment. Thought this will be limited to the various government bonds. You can actually get a Treasury bill, Treasury note, and one or both types of savings bonds. The only problem is that you may not be allowed to buy above some certain limit. For example, you will not be able to buy more than $10,000 security risk on either series EE or series I savings bonds.
Mutual Fund and ETF (Exchange Traded Fund)
When we talk of mutual fund or ETF, we are referring to pools of bonds of different investors. Such pools contain bonds with different maturity dates and may also contain different types of securities such as stocks. You can actually trade in a mutual bond pool through a broker by opening an account with them. Once you create an account, you can actually ask your broker to recommend some funds to you. You may also do your research online to some really good mutual funds. The advantage here is that of diversification of your investment and the ability to ripe from different interest rates.
Understanding the Issuer
No one will ever want to invest where he is not sure to receive what he invested with what the issuer promised him. Therefore, before you go on to investing in Government bonds, you have to understand the institution you are trading with and their level or reliability. If you are dealing directly with the U.S. Treasury directly through the Treasury Direct website, you can be 100% sure of receiving all what you’re due at the end of the maturity period, even when the economy is not strong or during economic downturns. There are also other corporations or organization through which you can trade in bonds. The best government bonds are issued through the U.S. Department of treasury and can be found at their website. Other bonds issuing agencies include:
Other U.S. State Government Agencies: Other government agencies such as Fannie Mae also issue government bonds. However, these agencies issue bonds at higher rates as compared with that bought through the Treasury Direct website, but there is also a higher risk involve with trading with such agencies. That notwithstanding, the risk is small compared to other agencies.
Municipal governments: Some bonds are also issued through municipal government agencies. These bonds also have some tax advantages, which to some extent depends on your tax bracket and location. The risk here is a little higher when compare to the risk involves in federal government bonds.
Foreign Governments Bonds: These are very uncertain bonds, which usually carry very high risk. They also have some of the lowest and high government bond yields. The main problem involves in this type of bonds is that their performance is greatly dependent on currency exchange rates which is never stable.
Corporations Bonds: This bond type is issued by companies. These bonds carry some of the highest risk simply because they rely mostly on the performance of the company. If the company is making profits, then the bonds may out perform most other bond types. On the other hand, if the company is faced with bankruptcy, you may be faced with the highest risk, ranging from non-payment of even your face investment with no interest on your investment. Therefore, before venturing in a corporate bonds, you must study the growth cycle of the company and be sure the company has a higher potential for growth.
Some other agencies also issue what is commonly known as mortgage-backed bonds. These types of bonds are often the most expensive and also carry some of the highest risk when compared to the other types of government-issued bonds.
Do you need more information?
The Treasury Direct bears host to a good amount of information you need to be able to trade successfully in the various government bonds. This website holds some of the most accurate information you will ever need, especially if you are planning to invest in any of the government bonds. Also available are the various schedules and the outcome of recent bond auctions and also the explanation of the auction process. Thus, this should be your one point stop for all your government bond investment needs. Do you need to know the current savings bonds rates or the various debts of the government just get to this website. Note also that, if you have to trade in savings bonds, you will be able to invest only through the Treasury Direct website. Government savings bonds are only offered for investment in the U.S. Department of Treasury website.
If you are in the market trying to get for yourself the best ways to invest in government bonds, then you should have gotten it from this article. Remember that you are investing your money, thus you need proper planning, education and most especially, go the right place for trading (for federal government bonds, go to the U.S. department of Treasury website-TreasuryDirect). Make sure you know the maturity date and interest rate of the bond you choose to invest in. that is not just for knowing sack, be ready to wait until its maturity period. The real benefits from investing in government bonds come only after its maturity date.