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Government Bond Market

Government Bonds

DEFINITION

A government bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date. Government bonds are usually denominated in the country's own currency. Another term similar to government bond is "sovereign bond". Technically any bond issued by a sovereign entity is a sovereign bond but sometimes the term is used to refer to bonds issued in a currency other than the sovereign's currency. If a government or sovereign is close to default on its debt the media often refer to this as a sovereign debt crisis.

RISKS

CREDIT RISKS

Government bonds in a country's own currency are sometimes taken as an approximation of the theoretical risk-free bond, because it is assumed that the government can raise taxes or create additional currency in order to redeem the bond at maturity. There have been instances where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis").

CURRENCY RISKS

Currency risk is the risk that the value of the currency a bond pays out will decline compared to the holder's reference currency. For example, a German investor would consider United States bonds to have more currency risk than German bonds (since the dollar may go down relative to the euro); similarly, a United States investor would consider German bonds to have more currency risk than United States bonds (since the euro may go down relative to the dollar). A bond paying in a currency that does not have a history of keeping its value may not be a good deal even if a high interest rate is offered.

INFLATION RISKS

Inflation risk is the risk that the value of the currency a bond pays out will decline over time. Investors expect some amount of inflation, so the risk is that the inflation rate will be higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by linking both interest payments and maturity payments to a consumer prices index.

MONEY SUPPLY

If a central bank purchases a government security, such as a bond or treasury bill, it increases the money supply, in effect creating money.

THE UNITED KINGDOM

In the UK, government bonds are called gilts. Older issues have names such as "Treasury Stock" and newer issues are called "Treasury Gilt". Inflation-indexed gilts are called Index-linked gilts. UK gilts have maturities stretching much further into the future than other European government bonds, which has influenced the development of pension and life insurance markets in the respective countries.


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