How much is a government bond worth
Government bonds: a special investment
The investor as a creditor
While shareholders become co-owners of the company by buying shares in the company, buyers of government bonds fulfill a different role. They are creditors of states to which they lend money.
In return, states or state institutions undertake to pay the creditors the nominal value of the bond after the term has expired and to regularly distribute interest.
Types of government bonds
Various forms of government bonds are issued in Germany. Their issuance is managed and coordinated by the German Finance Agency.
- Bunds: These bonds have the longest term with ten or 30 years. These bonds are used for the long-term financing of the budget.
- Federal bonds: This type of bond is issued with a term of five years. Federal bonds are used by the state for the medium-term financing of projects.
- Federal Treasury Notes: With a term of two years, they are predestined for short-term financing by states or state institutions and municipalities.
In the USA there are also three different forms of government bond: T-bills, T-notes and T-bonds. In Switzerland, government bonds are called "Confederates". In Great Britain the name is "Gilts".
Treasury notes abolished in 2012
Federal Treasury Bonds were popular German government bonds for a long time. In December 2012, the issuance of these bonds ended. They had a term of six or seven years.
The role of the European Central Bank (ECB)
Since the great debt crisis in Europe, the ECB has been buying up government bonds from crisis-ridden countries. In this way, the states are protected in the event of a payment obligation after the term has expired.
The ECB also prevents financially weak countries from getting into liquidity bottlenecks because nobody wants to buy the government bonds. Because the disadvantage of financially weaker countries is that they promise high interest rates, but because of their poor creditworthiness, nobody expects a secure payout at the end of the term.
The money that the ECB invests in buying bonds comes from fresh money that it puts into circulation.
The role of rating agencies
So-called “rating agencies” are responsible for assessing the creditworthiness. They use complicated procedures to determine how creditworthy a country is. In the European Union, rating agencies need appropriate approval in order to take action. There are various rating agencies around the world that are constantly being talked about. The best known include:
- Fitch Ratings
- Japan Credit Rating Agency Ltd.
- Scope ratings
- GBB rating
However, there is always criticism of the work of individual rating agencies. In some cases they are accused of partiality. They usually have a lot of power through their work. There are significant consequences if the credit rating of a country slips from AAA to BBB.
Gradation of ratings
The creditworthiness of countries can be classified with letters from A to C. AAA (triple A) is the top grade. Few states have such a credit rating. The worst rating is a CCC-. These are, for example, government bonds with a very high risk of default.
Market interest rate and yield on government bonds
The yield on a government bond is determined by the remaining term, the price of the bond and the nominal amount. In addition, superordinate factors such as creditworthiness, general market interest rates and the volatility of the stock market play a role.
The influence of market rates on the bond
With a bond purchase, there is a risk that the market interest rate will change significantly. The interest rate has an impact on the price of the bond, which is traded on the stock exchange. How the market interest rate turns out depends on the policy of the respective country or the central bank, for example the ECB.
If interest rates fall, the bond prices rise; if the market rate rises, the level of the bond falls. If an investor wants to sell his bond before maturity, he will make losses if market interest rates rise. If he sells at a low market interest rate, he can realize profits. As a rule, government bonds with a short term react more strongly to price developments than bonds with a long term. The latter are more strongly influenced by inflation.
If you want to resell your bond within the term, you should opt for a variable interest rate or bonds without interest at a low price (zero bonds). The return can be achieved through price gains through these bonds.
Yield, market rate and price of a bond
Example: An investor invests 5,000 euros in bonds with a term of five years and a price of 100 percent. The interest coupon is five percent, the market interest rate at the time of purchase is also five percent.
If the remaining term is two years and the market interest rate rises to seven percent, the rate is only 96 percent. In the event of a sale, the investor would lose EUR 200 and only receive EUR 4,800 for his bonds.
If the market interest rate falls to three percent and the remaining term is one year, the price rises to 102 percent and the investor makes a profit of 100 euros with a payout of 5,100 euros for the sale of the bonds.
Negative returns on government bonds
In July 2016, German government bonds with a term of ten years were issued for the first time with a negative yield. In 2015, Switzerland issued government bonds with negative interest rates for the first time. Spain also applied negative interest rates on short-term bonds.
The purchase of government bonds
Private investors can buy government bonds in Germany from banks and savings banks. There you get access to German government bonds such as federal bonds, federal bonds or federal treasury notes, each of which differs in the amount of interest and the maturity.
Which bonds can be bought?
In principle, like shares, German private investors can acquire government bonds from all countries that offer such bonds. However, investors need to take currency conversion into account.
It represents an additional risk when it comes to government bonds from countries that do not belong to the euro area. In addition, investors should check the creditworthiness of the respective country carefully.
For practical reasons and for security reasons, most private investors only buy government bonds from countries with very high credit ratings. However, the return is usually lower in this case.
Another way to hedge is to invest in funds. In an investment portfolio, they are considered a safe investment that can offset any fluctuations in the value of equity funds.
The valuation of government bonds
Government bonds can be valued using various methods.
- The common method is the so-called "cash value method". The investor looks at what amount he can receive at the specified interest rate on his bond at the end of the term. This process is called "compounding". The so-called “discounting” assumes the future value of the bonds. The current market interest rates are deducted from this.
- Another way of valuing government bonds is to calculate the effective interest rate. The nominal interest rate (coupon interest) and a possible interest gain through the purchase price are taken into account.
Transaction costs can reduce returns
Anyone who buys government bonds must expect transaction fees for the purchase or sale. As a rule, these are five to ten euros if he invests 1,000 euros in bonds through a bank.
If the interest rate on the bonds is particularly low, the transaction costs can significantly reduce the return. It is therefore advisable to hold government bonds until the end of the term so as not to incur additional costs.
Finance agency debt register account
Government bonds can be purchased from the Deutsche Finanzagentur without going through a bank. The free “debt register” account is available to the investor to manage the bonds.
All transactions processed through it are free of charge. There is no need for advice, as is possible with a bank custody account.
Falling prices of government bonds in Europe
When the ECB announced in 2015 that it would buy up many government bonds from European countries to stabilize the economy, the prices for bonds in Europe rose.
Due to the high demand, more bonds were bought, which further boosted prices. However, a short time later there was a phenomenon that caused prices to fall sharply. Even among economists and bond professionals, there was uncertainty about the exact reasons for the price losses.
Overall, however, the price losses led to criticism of the ECB's bond purchase. Critics believe that such purchases, while improving in the short term, have no long-term effect.
Is it worth buying government bonds?
The purchase of government bonds is generally considered a very safe investment if the issuing state has a high credit rating. However, a high credit rating usually means a lower return because lower interest rates are paid.
Benefits of Government Bonds
- Safe form of investment
- Can be used even from small amounts
- Open to all people
- Can easily be bought
Cons of government bonds
- Long-term commitment required for higher returns
- Inflexible investment
- Only moderate interest
Alternatives to the government bond
If you don't want to invest your money in government bonds, but are looking for a long-term investment with moderate interest, you can also use fixed-term deposit offers from banks. There, returns of up to 2 percent are possible with flexibly selectable terms.
Those who want a higher return can invest their money in stocks or in funds. However, this type of investment also increases the investment risk.
What do government bonds with negative interest rates bring?
In 2012, the federal government raised negative interest rates on federal bonds for the first time. For investors, this means that they have to pay annually to borrow money from the German state. In return, Germany's creditworthiness is so high that the default risk of German government bonds is almost zero. That is why the demand for German government bonds remains very high.
As a rule, investors in government bonds with negative interest rates are institutional investors who have to invest in bonds and investors who speculate on price gains on the stock exchanges despite negative interest rates.
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