What a government bond actually is

A government bond is a loan you give to a government. When you buy a bond, you hand over money to the federal government, a state, or a city. That government promises to pay you back the full amount on a specific date, plus interest along the way. You are not buying a piece of the government or a stake in anything — you are straightforward a lender.

The government uses the money from bond sales to pay for roads, schools, military operations, or to cover a budget shortfall. Instead of raising taxes when ready, the government borrows from bond buyers and repays them over time. This is how governments borrow money, just as you might borrow from a bank.

The interest the government pays you is called the coupon or coupon rate. If you buy a $1,000 bond with a 3 percent coupon, the government will pay you $30 per year (usually in two payments of $15 each) until the bond matures. On the maturity date — the day the loan ends — the government gives you back your original $1,000.

Key Takeaways

  • A government bond is a loan to a government that pays you interest; the government repays the full amount on a set date called the maturity date.
  • U.S. Treasury bonds are issued by the federal government and are considered the safest bonds because they are backed by the full power of the U.S. government to tax and borrow.
  • Bonds with longer maturity dates typically pay higher interest rates than shorter-term bonds because you are lending money for a longer period.
  • You can buy government bonds directly from the government through TreasuryDirect, or through a bank or brokerage firm, and you can sell them before they mature if you need the money.
  • The price of a bond can go up or down before maturity depending on interest rates and economic conditions, so you may gain or lose money if you sell early.

The three main types of U.S. Treasury securities

The U.S. federal government issues three kinds of bonds, each with a different maturity date. The maturity date is how long you must wait to get your money back.

Treasury bills (or T-bills) mature in less than one year — typically in 4 weeks, 8 weeks, 13 weeks, 26 weeks, or 52 weeks. You buy them at a discount, meaning you pay less than the face value. For example, you might pay $990 for a $1,000 bill, and when it matures in 13 weeks, you get $1,000. The $10 difference is your interest.

Treasury notes mature in 2, 3, 5, 7, or 10 years. These pay interest every six months. A 5-year note pays you twice a year for five years, then returns your principal on the maturity date.

Treasury bonds mature in 20 or 30 years. These are the longest-term securities the federal government offers. Because you are lending money for decades, they typically pay higher interest rates than notes or bills.

Why interest rates on bonds change

The interest rate a government bond pays depends on several things. First, it depends on how long you are lending the money. A 30-year bond pays more interest than a 2-year note because you are taking on more risk — the economy could change, inflation could rise, or you might need the money before 30 years pass.

Second, it depends on what the Federal Reserve is doing. The Federal Reserve sets a target interest rate that banks charge each other for overnight loans. When the Fed raises this rate, new government bonds pay higher interest to stay competitive. When the Fed lowers rates, new bonds pay less. If you already own a bond paying 2 percent and new bonds start paying 4 percent, your bond becomes less attractive — its price falls if you try to sell it.

Third, it depends on inflation expectations. If people expect inflation to rise, they demand higher interest rates to make up for the fact that their money will be worth less in the future. If inflation expectations fall, interest rates on new bonds fall too.

How to buy government bonds

You can buy U.S. Treasury securities directly from the federal government through TreasuryDirect, a website run by the Bureau of the Fiscal Service. You create an account, link a bank account, and bid on securities during auctions held throughout the year. There are no fees, and the minimum purchase is $100 for most securities.

You can also buy bonds through a bank or brokerage firm like Fidelity, Charles Schwab, or Vanguard. These firms charge a fee or commission, but they handle the paperwork and may offer more flexibility in how you buy and sell. Some banks let you buy bonds in person at a branch.

If you want to buy bonds issued by your state or city, you typically go through a broker or bank. These are called municipal bonds or munis. They work the same way as Treasury bonds — you lend money, the government pays you interest, and you get your principal back at maturity — but they are issued by states, cities, or local agencies instead of the federal government.

What happens if you need to sell before maturity

You do not have to hold a bond until it matures. You can sell it to another investor at any time through a broker or bank. However, the price you get depends on what has happened to interest rates since you bought it.

If interest rates have risen since you bought your bond, new bonds pay more interest than yours. To make your bond attractive to a buyer, you have to sell it at a discount — a lower price than you paid. If interest rates have fallen, your bond pays more than new bonds, so you can sell it at a premium — a higher price.

For example, suppose you buy a $1,000 Treasury note paying 3 percent interest. Six months later, the Federal Reserve raises rates and new notes pay 5 percent. If you try to sell your note, a buyer will want a discount because they could get a higher interest rate elsewhere. You might have to sell it for $950 to find a buyer. You lose $50 even though the government will still pay you back the full $1,000 at maturity — but you no longer own it.

Why people buy government bonds

People buy government bonds for several reasons. Safety is the main one. U.S. Treasury securities are considered the safest bonds in the world because the U.S. government has never defaulted — it has always paid back what it owes. If you hold a bond to maturity, you will get your money back.

People also buy bonds for predictable income. If you buy a 10-year Treasury note paying 4 percent, you know exactly how much interest you will receive every six months for the next decade. This makes bonds useful for people who need steady cash flow, like retirees.

Bonds also serve as a hedge against stock market volatility. When stock prices fall, bond prices often rise because investors move money into safer investments. Many people hold a mix of stocks and bonds to reduce overall risk.

The difference between Treasury securities and other government bonds

Treasury securities are issued by the U.S. federal government and are backed by the full taxing power and borrowing authority of the United States. This is why they are considered the safest bonds available.

Municipal bonds are issued by states, cities, and local agencies. They are generally safer than corporate bonds (bonds issued by companies) but riskier than Treasury securities because a city or state could theoretically run out of money and default. However, municipal bonds often have a tax advantage: the interest you earn is usually not subject to federal income tax, and sometimes not subject to state income tax either.

Agency bonds are issued by government-sponsored enterprises like Fannie Mae or Freddie Mac, which buy mortgages from banks. These are backed by the mortgages themselves rather than by the full faith and credit of the U.S. government, so they pay slightly higher interest than Treasury securities but carry slightly more risk.

Frequently Asked Questions

Can I lose money on a government bond?

If you hold a bond to maturity, you will get back exactly what you paid for it (plus interest). However, if you sell before maturity, you can lose money if interest rates have risen, because you will have to sell at a discount. You cannot lose money due to the government defaulting on a Treasury bond, but you can lose purchasing power if inflation rises faster than the interest rate your bond pays.

What is the difference between a bond and a CD?

A certificate of deposit (CD) is a savings product offered by banks; you deposit money for a set period and earn a fixed interest rate. A bond is a loan to a government or company. CDs are insured by the FDIC up to $250,000, while Treasury bonds are backed by the government itself. Bonds can be sold before maturity, but CDs typically charge a penalty if you withdraw early.

How much interest will I earn on a Treasury bond?

The interest rate varies depending on the type of security, how long it matures, and current economic conditions. You can see current rates on the TreasuryDirect website or through any broker. Rates change constantly as the Federal Reserve adjusts policy and inflation expectations shift.

Do I have to pay taxes on bond interest?

Interest from U.S. Treasury securities is subject to federal income tax but not state or local income tax. Interest from municipal bonds is usually not subject to federal income tax. Interest from corporate bonds is subject to both federal and state income tax. You will receive a Form 1099-INT from the issuer reporting the interest you earned.

What happens if the government defaults on a bond?

The U.S. federal government has never defaulted on its debt. However, if it did, you would not receive your principal or interest payments. This is why Treasury securities are considered the safest bonds — the risk of default is extremely low. State and local governments have occasionally defaulted, which is why municipal bonds carry slightly more risk.