A person who buys government bonds is lending the government money. “Government bonds” is a general term that encompasses a wide range of bonds issued by a variety of governmental entities, including:
Tax-Exempt Municipal Bonds
Municipal bonds (or “munis”) are debt obligations issued by states, cities, counties, school districts, public utility districts, redevelopment agencies, special districts, or other local governmental agencies. When an investor purchases a municipal bond, the investor is lending money to a state or local government entity, which in turn, promises to pay a specified interest rate (usually paid semiannually) and pay back the principal on a specific maturity date.
Municipal securities consist of both short-term issues (“notes”), which typically mature in one year or less, and long-term issues (“bonds”), which mature in more than one year.
Notes are used by an issuer to raise money for a variety of reasons, including: covering irregular cash flows; meeting unanticipated deficits; raising immediate capital for projects until long-term financing can be arranged; and in anticipation of future revenues such as taxes, state or federal aid payments, and future bond issuances.
Bonds are usually sold to finance capital project, such as the construction of highways, schools, or sewer systems. In addition, bonds are often used to fund day-to-day operations. The two most common types of municipal bonds are: (1) general obligation bonds, backed by the credit and taxing power of the issuer; and (2) revenue bonds, backed by revenues from a specific project or source.
In the United States, municipal bonds are attractive to many investors because the interest income is generally exempt from federal income taxes and may also be exempt from state and local taxes for residents who reside in the state where a bond is issued.
Suppose a school district decides to construct a new high school for $10 million and would like to sell bonds with a 30-year term to fund the project. Depending on whether the issuer chooses to price the bonds using a public offering or private placement process, financing costs and interest rates may vary. Let’s assume that financing costs total $250,000 and a 5% coupon across all maturities. In addition, let’s also assume that the issuer is also required to deposit $750,000 into a reserve fund as additional security for the bonds. Including these costs, the total par amount for this bond issue will be $11 million. As a result, the issuer would sell 2,200 bonds to investors for $5,000 each (in general, municipal bonds carry a face value of $5,000). The issuer will make annual debt service payments (consisting of semi-annual interest payments and annual principal payments) of approximately $715,000 over the 30-year life of the bonds, at which point, no additional payments are required.
Taxable Municipal Bonds
There are situations in which the federal government will not subsidize the financing of certain activities that do not provide a significant benefit to the general public. As a result, not all municipal bonds are exempt from federal taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but maintain a tax-exempt status at the state (and often local) level for interest paid to residents of the state of issuance. As a result, federally taxable municipal bonds offer yields more comparable to those of other taxable sectors, such as corporate bonds, than to those of tax-exempt municipals.
Bank Qualified Bonds
Similar to other investors, banks purchase municipal bonds to earn interest that is exempt from Federal income taxes. Historically, banks were the major purchasers of tax-exempt bonds. All this changed with the passage of the Tax Reform Act of 1986 (the “Act”). Banks are now prohibited from deducting the interest costs of tax-exempt municipal bonds unless the bonds are designated as “qualified tax-exempt obligations.”
In order for bonds to be qualified tax-exempt obligations, the bonds must be:
(i) issued by a “qualified small issuer” (one who reasonably expects to issue no more than $10 million of bonds in a calendar year),
(ii) issued for public purposes, and
(iii) designated as qualified tax-exempt obligations.
As a result, the Act effectively created two classes of municipal bonds: bank qualified (“BQ”) and non-bank qualified. Bonds that meet the above criteria are designated as “bank qualified” and allow for banks to deduct 80% of the interest costs. Non-bank qualified bonds are those that do not meet the above criteria and, therefore, are not exempt from Federal taxes for banks. As a result, bank qualified bonds are generally more desirable to banks and carry a lower interest rate than non-bank qualified bonds.
Under the American Recovery and Reinvestment Act of 2009, the bank qualified bond limit was increased from $10 million to $30 million. In 2012, the U.S. Senate approved a transportation bill (S. 1813) that includes a provision to increase the bank qualified debt limit to $30 million between July 1, 2012, and June 30, 2013. Legislation has also been introduced to permanently increase the bank qualified bond limit to $30 million (S. 1016).
The government bond sector is a broad category that includes federal (or “sovereign”) debt that is issued and backed by a central government. U.S. Treasuries, Canadian Bonds, U.K. Gilts, German Bunds, Japanese Government Bonds, and French OATs are all examples of sovereign government bonds. Sovereign bonds issued by these major industrialized countries are generally considered to have very low default risk and are among the safest investments available.
In the United States, the U.S. Treasury issues three types of securities: bonds, bills, and notes. Each is distinguished by the amount of time from the initial sale of the bond to maturity. Treasury Bills (or “T-bills”) are short-term instruments with maturities of no more than one year. Treasury Notes are intermediate-term investments, typically issued in maturities of two, three, five, seven, and 10 years. Treasury Bonds cover terms of longer than 10 years, and are generally issued in maturities of 30 years. Treasury Bills, Notes, and Bonds are all issued in face values of $1,000; although, there are different purchase minimums for each security type.
A number of governments also issue bonds that are indexed to inflation. For an inflation-adjusted bond, the principal and/or interest is adjusted periodically to reflect changes in the inflation rate, thus providing a “real,” or inflation-adjusted return. These inflation-adjusted securities are known as “TIPS” (Treasury Inflation-Protected Securities) in the U.S. and “linkers” in Europe. In the case of TIPS, the principal amount of bonds is adjusted semi-annually by the Consumer Price Index.
In the U.S., “STRIPS” (Separate Trading of Registered Interest and Principal of Securities) are another type of debt issuance where a traditional Treasury bond’s principal has been separated (“stripped”) from its coupon. This type of security is otherwise known as a zero-coupon bond; that is, STRIPS make no periodic interest payments. Instead, investors buy them at a discount and receive the full face value of the bonds at maturity.
Treasury STRIPS Explained
Central governments pursue various goals (e.g., supporting the housing market, encouraging small business growth, providing student loans, etc.) through quasi-government agencies known as Government Sponsored Enterprises (“GSEs”). These government-sponsored and government-owned corporations are affiliated with, but technically separate from, the government. In the U.S., examples of GSEs include Fannie Mae, Freddie Mac, Sallie Mae, and the Federal Home Loan Banks.
A number of these GSEs issue bonds to support their operations. Some agency bonds are explicitly backed by the “full faith and credit” of the central government, while others are not. For example, the U.S. government guarantees bonds issued by Ginnie Mae, a mortgage agency, but does not explicitly guarantee bonds issued by Fannie Mae and Freddie Mac, both of which buy mortgages from banks. Although, in September 2008, the Federal Housing Finance Agency took conservatorship of Fannie Mae and Freddie Mac in response to the mortgage meltdown. The U.S. Treasury has now committed to provide the necessary funding to backstop these GSEs.
In addition to bonds issued by agencies of individual governments, supranational and international institutions, like The World Bank and the European Investment Bank, also issue bonds to finance public projects and/or development.
Developing economies around the world, known as emerging markets, are quickly establishing themselves as key players in the global economy. Emerging market bonds are debts issued by these countries and corporations based in those nations. These countries include most of Africa, Asia (excluding Japan), Eastern Europe, Latin America, the Middle East, and Russia.
While emerging market bonds can offer attractive yields, higher yields tend to be accompanied by greater risk. The risks of investing in emerging market bonds include the risks that accompany all debt issues (e.g., inflation risk, reinvestment risk, market risk, etc.). However, these risks are heightened due to the potential political and economic volatility found in most developing nations.