BUS202: Principles of Finance

A government bond is a bond issued by a national government denominated in the country's domestic currency.

TERMS

• purchasing power

  Purchasing power (sometimes retroactively called adjusted for inflation) is the amount of goods or services that can be purchased with a unit of currency.

• purchasing power parity

  a theory of long-term equilibrium exchange rates based on relative price levels of two countries

A government bond is a bond issued by a national government, generally promising to pay a certain amount (the face value) on a certain date as well as periodic interest payments. Such bonds are often denominated in the country's domestic currency. Government bonds are sometimes regarded as risk-free bonds because national governments can raise taxes or reduce spending up to a certain point. In many cases, they "print more money" to redeem the bond at maturity. Most developed country governments are prohibited by law from printing money directly, that function having been relegated to their central banks. However, central banks may buy government bonds in order to finance government spending, thereby monetizing the debt .

Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. Investors in sovereign bonds denominated in foreign currency have the additional risk that the issuer may be unable to obtain foreign currency to redeem the bonds. For example, in the 2010 Greek debt crisis the debt was held by Greece in Euros. One proposed solution was for Greece to go back to issuing its own Drachma.

In the primary market, Government Bonds are often issued via auctions at Stock Exchanges. There are several different methods of issuing such as auctions, including guarantee, combined auction and guarantee, and others. There are two types of interest rates: fixed and floating. In the secondary market, government bonds are traded at Stock Exchanges. Unlikely equity system, the bond secondary market uses a completely different system with different method of trading. At the secondary market, each bond will be assigned with very own bond code (ISIN code).

Government bonds are usually referred to as risk-free bonds because the government can raise taxes or create additional currency in order to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"), although this is very rare (see national bankruptcy). Another example is Greece in 2011. Its bonds were considered very risky, in part because Greece did not have its own currency.

There is currency risk for government bondholders. As an example, in the U.S., Treasury securities are denominated in U.S. dollars. In this instance, the term "risk-free" means free of credit risk. However, other risks still exist, such as currency risk for foreign investors (for example non-U.S. investors of U.S. Treasury securities would have received lower returns in 2004 because the value of the U.S. dollar declined against most other currencies). Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation rate is higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by increasing the interest rate given to the investor as the inflation rate of the economy increases.