What are government bonds and bonds

Government bonds and federal bonds

Security, but hardly any return

Hendrik Buhrs
Expert for banks and stock exchanges As of October 30, 2020

Hendrik Buhrs

Hendrik Buhrs is an editor in the bank and insurance team. Before joining Finanztip, he reported on economic and consumer issues for the radio programs of the Hessian and later of the West German Broadcasting Corporation. Hendrik studied economics in Münster and Exeter. He gained his first professional experience at Radio Q and on Recklinghausen local radio. He likes to invest the money he has saved in travel.

  • Government bonds are debt securities that are issued by countries.
  • Anyone who buys a government bond gives the respective country a loan. In return, the buyer receives fixed interest payments and his money back at the end of the term.
  • There are government bonds with terms ranging from a few months to more than 30 years. Many are traded on stock exchanges.
  • Bonds are subject to price fluctuations. When interest rates rise, their prices fall; when interest rates fall, they rise.
  • If you hold a bond until the end of the term, price fluctuations are irrelevant.
  • Because of the extremely low yields on government bonds, we currently advise against buying them. Often the return is even negative. Instead, we recommend overnight and fixed-term deposits because they generate higher returns.

States finance theirs by issuing bonds Budget deficits. The papers have different names in each country. American government bonds with terms between one and ten years are called, for example, “T-Notes” or “Treasury Notes”. In Great Britain they call themselves “Gilts”, and in Germany they operate under the umbrella term Federal securities.

Government bonds of the Federal Republic

The Federal Republic of Germany offers investors a number of different bonds that differ in terms of maturity and interest rate. The papers are among the safest in the world. Rating agencies give federal government bonds the top AAA rating. In other words, they rate the risk of failure as extremely low.

The exact designation of individual federal securities depends on the respective term. Federal bonds with a term of up to two years are called federal treasury notes, five-year papers are federal bonds.

In addition, the federal government issues bonds with a term of 7, 10, 15 and 30 years - the classic federal bonds. You can find an overview of all federal securities that are currently in circulation on the website of the Federal Finance Agency.

Important characteristics of government bonds

Investors who buy a government bond give the country in question a loan for a set period of time. In return, they receive a fixed interest rate, usually annually. The financial sector also calls this interest rate the coupon. Normally, the longer the term, the higher the interest. After all, investors forego their money longer. In addition, the probability of failure increases with increasing runtime.

Interest - How much interest a state has to offer in order for its bonds to be bought on the market also depends on its creditworthiness. High creditworthiness means low interest rates, poor creditworthiness means higher.

Creditworthiness - What constitutes excellent creditworthiness was well seen during the financial crisis. Many billions flowed from highly indebted euro countries to Germany in federal bonds, as international investors consider them to be a particularly safe investment. The result is that returns in this country have reached historic lows.

Rate fluctuations - Federal bonds are classed as hand-safe securities. This means that payment defaults are as good as excluded by the legislator. However, that does not mean that there can be no fluctuations in value. The prices of government bonds are flexible - unlike the coupon. Interest rate developments have a major impact on prices. If the level falls, the prices of government bonds rise. They fall when interest rates rise.

As an investor, you can neglect price fluctuations if you hold a bond until the end of the term. Because then you will get the full face value back. That is the amount of money that is on the government bond.

Liquidity - Federal bonds are also very liquid securities. Liquid means that they can be sold on the stock exchange at any time. The current price depends on supply and demand.

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How a changed market interest rate affects the price

In the case of government bonds, as with other bonds, investors have to distinguish between the coupon and the yield. The fixed annual interest payment is not the same as the return. For the investor, however, the return is the decisive factor: it indicates how high the annual return will be in relation to the invested capital until the end of the term. The yield on government bonds fluctuates daily with their prices. If prices rise, returns fall - and vice versa.

The Federal Finance Agency publishes the current prices and yields of federal securities every day. Example: The DE0001102465 bond with a remaining term of 8.3 years brought a return of -0.68 percent in October 2020. The price was 107.96 percent of the nominal value, the coupon is 0.25 percent. If the purchase price of a bond is more than 100 percent of the face value, the yield is lower than the coupon. On the other hand, if the price were quoted at 90 percent, for example, the expected return would be higher than the coupon.

As mentioned, bond prices are primarily driven by interest rate developments. The longer the term of a bond, the more the prices react, as the following calculation shows.

example 1: A bond offers an annual return of 5 percent. The current market interest rate is also 5 percent. The price of the bond is 100 percent. How does the price of bonds with different remaining terms change when the market interest rate rises by one percentage point to 6 percent?

Example calculation 1

Remaining term in years151030
Rate in percent99,1 95,8 92,6 86,2 

Source: Finanztip calculation

Example 2: Same starting point as above, but the market interest rate now drops by one percentage point to 4 percent.

Example calculation 2

Remaining term in years151030
Rate in percent101,0104,5108,1117,3

Source: Finanztip calculation

The two examples illustrate that a change in interest rates on the capital market has a stronger effect on the price of a bond, the longer its remaining term. The price of a ten-year bond reacts much more strongly than that of a one-year bond because it has to compensate for the change in interest rates for more years.

For you as an investor, that usually means: If you might want to resell a bond during its term and you expect interest rates to rise in the next few years, you should buy short-term bonds. This way you can keep price losses small. On the other hand, if you expect interest rates to fall, you should prefer bonds with long maturities. Because when the market interest rate falls, the prices of long-term bonds rise faster than those of short-term paper.

At the moment, however, no noteworthy price gains are to be expected for government bonds, because their yields can hardly fall any more. A federal bond with a ten-year term, for example, now brings a negative return of less than -0.5 percent per year.

Alternatives to government bonds

We therefore recommend overnight and fixed-term deposits. Good accounts generate even higher income and also offer a high level of security: bank deposits of up to 100,000 euros are protected by deposit insurance in the EU. The disadvantage is that investors cannot access time deposits during the term. You can read about how this problem can be largely eliminated in our fixed-term deposit guide.

Buying and selling government bonds

You can buy or sell federal bonds at any time on the stock exchange at the current price via an online bank. There are buying and selling costs. When trading foreign bonds, the transaction costs are usually so high that the purchase is not worthwhile for private investors. If you also want to invest in European or international government bonds, you would be better off with bond funds. However, the prospects for returns on these products are currently hardly better than those of Bunds.

To buy bonds, funds and other securities, you need a custody account and access to the stock exchanges.

More on this in the securities account guide

  • With the right securities account, you pay little for buying and selling equity funds (ETFs).
  • Finanztip recommendations: Among the cheap and versatile custody accounts did the best: ING, Comdirect and Consorsbank and DKB. The cheapest providers are: Smartbroker, Scalable Capital (Free Broker) and Trade Republic.

To the advisor

Dr. Manuel Kayl

Dr. Manuel Kayl

Manuel Kayl was responsible for investment topics at Finanztip. The doctor of physics worked as an investment strategist and risk manager at the Dutch insurance company a.s.r. after doing research at the Geneva research center Cern as well as at Nikhef and the University of Amsterdam. He left Finanztip on August 31, 2016.

Markus Neumann

Markus Neumann

Until October 2015, Markus Neumann wrote for Finanztip about all aspects of investing. The experienced financial journalist has written numerous publications on the subject of investments, which were published by the Berliner Fuchsbriefe-Verlag and the Stiftung Warentest. After his internship at Heinrich Bauer Verlag in Hamburg, he worked for many years as an editor and reporter.

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