A government bond is a loan you make to the federal, state, or local government, and they pay you back with interest

When you buy a government bond, you are lending money to a government body. That government promises to pay you back the full amount on a specific date — called the maturity date — and to pay you interest along the way. The U.S. Treasury, your state government, or your city might issue the bond. You are not buying a piece of ownership in anything. You are a creditor, not a shareholder. The government uses the money you lend to pay for roads, schools, military operations, or other expenses.

The bond itself is a certificate or electronic record that shows how much you lent, what interest rate you will receive, and when you will get your money back. You can hold it until maturity and collect the full amount, or you can sell it to someone else before it matures — though the price you get depends on whether interest rates have risen or fallen since you bought it.

Key Takeaways

  • A government bond is a debt instrument where you lend money to a government and receive interest payments in return until the bond matures.
  • The three main types are Treasury bonds issued by the federal government, municipal bonds issued by states and cities, and savings bonds you buy directly from the Treasury.
  • Interest payments on Treasury and savings bonds are taxed by the federal government but not by state or local governments, while municipal bond interest is usually tax-free at all levels.
  • You can sell a bond before it matures, but the price you receive will be higher or lower depending on whether interest rates have risen or fallen since you bought it.
  • Bonds are considered lower-risk investments than stocks because the government is obligated to repay you, though the interest rate you earn is usually lower than stock returns.

The three main types of government bonds and who issues them

Treasury bonds are issued by the U.S. Department of the Treasury. The federal government uses the money to pay for defense, Social Security, infrastructure, and other national expenses. Treasury bonds come in three main lengths: Treasury bills mature in one year or less, Treasury notes mature in two to ten years, and Treasury bonds mature in twenty to thirty years. The longer you lend the money, the higher the interest rate you typically receive.

Municipal bonds are issued by state and local governments — cities, counties, school districts, and public utilities. They use the money to build schools, highways, water systems, and other local infrastructure. The interest you earn on most municipal bonds is not taxed by the federal government or your state government, which makes them attractive to people in higher tax brackets.

Savings bonds are issued directly by the Treasury and sold through the Treasury Department's website, TreasuryDirect. Series EE and Series I bonds are the most common types. You buy them at face value and they grow in value over time. Series I bonds adjust their interest rate every six months based on inflation, while Series EE bonds earn a fixed rate. You cannot sell savings bonds to someone else — you can only hold them or cash them in.

How interest payments work and when you receive them

Most government bonds pay interest twice a year. The bond certificate or confirmation shows the coupon rate — the percentage of the bond's face value you will receive each year. If you own a $1,000 bond with a 3 percent coupon rate, you receive $30 per year, paid in two installments of $15 each. The payment dates are set when the bond is issued and do not change.

Savings bonds work differently. They do not make regular interest payments. Instead, the bond's value increases each month, and you receive all the interest when you cash it in or when it reaches final maturity. If you cash in a Series EE bond before five years have passed, you lose the last three months of interest as a penalty.

The interest rate you receive depends on market conditions when the bond is issued. If the Federal Reserve raises interest rates, newly issued bonds will pay higher rates. If you own an older bond paying a lower rate, its value on the secondary market will drop because buyers can get better rates elsewhere.

What happens when a bond reaches maturity

On the maturity date, the government sends you the face value of the bond — the original amount you lent. For example, if you bought a $5,000 Treasury bond that matures in ten years, you receive $5,000 on that date. You also receive the final interest payment for that period. After that, the bond is done.

You then have to decide what to do with the money. You can buy another bond, invest it elsewhere, or spend it. The government does not automatically reinvest your money or roll it into a new bond unless you arrange that yourself.

If you own a savings bond, the maturity date is much longer — often thirty years or more. You can cash it in anytime after the first year, but if you hold it to final maturity, you receive the full accumulated value.

Buying and selling bonds before maturity

You can buy Treasury bonds through a bank, a brokerage firm, or directly from the Treasury Department through TreasuryDirect. Municipal bonds are usually bought through a broker. Savings bonds are bought only through TreasuryDirect.

If you want to sell a bond before it matures, you can do so on the secondary market through a broker. The price you receive depends on current interest rates. If interest rates have fallen since you bought the bond, your bond is worth more because it pays a higher rate than new bonds. If interest rates have risen, your bond is worth less. You might also pay a commission to the broker for handling the sale.

Treasury bonds are straightforward to sell because there is a large, active market for them. Municipal bonds can be harder to sell quickly, especially if they are issued by a small municipality. Savings bonds cannot be sold to anyone else — you can only cash them in with the Treasury.

Tax treatment of bond interest

Interest from Treasury bonds is taxed by the federal government but not by state or local governments. This is one reason Treasury bonds appeal to people living in high-tax states. If you live in New York and earn $1,000 in Treasury bond interest, you owe federal income tax on it but not New York state income tax.

Interest from municipal bonds is usually not taxed by the federal government or your state government, provided the bond was issued by a government in your state. A bond issued by your home state is triple tax-free: no federal, state, or local tax. A bond issued by another state is usually federally tax-free but may be subject to your home state's tax — this varies by state.

Interest from savings bonds is taxed by the federal government. You can choose to pay the tax each year as interest accrues, or you can wait and pay all the tax when you cash in the bond. State and local governments do not tax savings bond interest.

Why bond prices move when interest rates change

Bond prices and interest rates move in opposite directions. This is the most important thing to understand if you plan to sell a bond before maturity.

Imagine you bought a $1,000 Treasury bond paying 3 percent interest per year. You receive $30 annually. Then the Federal Reserve raises interest rates, and new Treasury bonds now pay 5 percent. A new $1,000 bond pays $50 per year. Your old bond paying $30 is less attractive. If you try to sell it, buyers will offer you less than $1,000 because they can get a better rate elsewhere. You might receive $900 for it.

The opposite happens if interest rates fall. If new bonds pay only 1 percent, your 3 percent bond becomes valuable. Buyers will pay more than $1,000 for it — perhaps $1,100 — because they want the higher interest rate. If you hold the bond to maturity, you always receive the full $1,000 face value regardless of what happens to interest rates. The price fluctuation only matters if you sell early.

The difference between bonds and stocks as investments

Bonds and stocks are both investments, but they work very differently. When you buy a stock, you own a small piece of a company and share in its profits and losses. When you buy a bond, you are a lender, not an owner. You receive a fixed interest payment regardless of whether the company or government is doing well or poorly.

Bonds are generally considered lower-risk than stocks because the government or company is legally obligated to pay you back. If a company goes bankrupt, bondholders are paid before stockholders. However, the interest rate on a bond is usually lower than the average return on stocks over long periods. You are trading higher potential returns for lower risk and more predictable income.

Government bonds are the lowest-risk bonds because the government can print money and raise taxes to pay its debts. A U.S. Treasury bond is considered one of the safest investments in the world. Municipal bonds carry slightly more risk because cities and states can face budget crises, though defaults are rare.

Frequently Asked Questions

Can I lose money on a government bond?

If you hold a bond to maturity, you receive the full face value and all promised interest payments, so you do not lose money. If you sell before maturity and interest rates have risen, you will receive less than you paid for it. The longer the bond's maturity, the bigger the price drop when rates rise. You can avoid this loss by straightforward holding the bond until it matures.

What is the difference between a bond's coupon rate and its yield?

The coupon rate is the interest percentage printed on the bond when it is issued — it never changes. The yield is the actual return you earn, which depends on the price you paid for the bond. If you buy a bond at a discount, your yield is higher than the coupon rate. If you pay a premium, your yield is lower. Yield is what matters when comparing bonds to other investments.

How do I know if a municipal bond is safe?

Municipal bonds are rated by agencies like Moody's and Standard & Poor's. Ratings range from AAA (safest) to C or lower (highest risk). You can find the rating before you buy. Bonds issued by large, stable cities and states are safer than bonds from smaller municipalities with budget problems. Your broker can show you the rating and the issuer's financial history.

Should I buy individual bonds or a bond fund?

Individual bonds give you predictable income and a may provide maturity date if you hold to the end. Bond funds pool many bonds together and let you invest a smaller amount, but their value changes daily and they do not have a maturity date. Bond funds are easier for beginners because they are diversified, but individual bonds are simpler if you want to know exactly when you will receive your money back.

Can I buy Treasury bonds directly from the government?

Yes, through TreasuryDirect, the Treasury Department's website. You can buy Treasury bills, notes, and bonds directly without paying a broker commission. You set up an account, link a bank account, and bid in Treasury auctions held regularly. Savings bonds are also sold only through TreasuryDirect. Banks and brokers also sell Treasury bonds, but they charge a fee.