How Government Bonds Work

There are many different kinds of government bonds also known as fixed or set income securities since the amount of interest the bond generates yearly is fixed when it is sold and nothing affects that outcome. Many people buy government bonds as a good secure investment with no surprises.

Many people considering investing in the bond market want to know just how do government bonds work. Basically a bond is a loan to the bond issuer, in this case the government, and the investor receives a fixed amount of interest periodically (most times in the form of semi-annual coupons) for the life of the bond. When the bond matures (anywhere from 3 months to 30 years) the bond seller repays the amount invested in the bond to the investor.

A good example of how the typical bond works would be as follows: The investor buys a 50,000 dollar bond for 10 years with a 5% coupon. Over the period of the 10 years the investor would collect 5% annually or $2500 in two semi-annual payments of $1250. At the end of the 10 years the investor would then be paid his original investment of $50,000. In the 10 year term of the bond the investor would have profited $25,000.

Types of bonds include government or treasury bonds which are usually the lowest return but also carry the lowest risk. These are also exempt from state and local tax. There is also the government agency bonds which are government sponsored entities such as Fannie Mae and Freddie Mac. Many agency bonds are tax exempt but those from Fannie and Freddie are not. The most notable of bonds, the U.S Savings bond falls in this category and the interest on these is fully taxable.

Municipal bonds are among the most popular because they are for the most part tax exempt. These are used by states, cities and municipalities for improvement projects. The yield for Munis is usually higher because of their tax-free status but this is dependent upon what tax bracket you are in.

Two other types of bonds are corporate and mortgage bonds. These bonds are fully taxable and the corporate bonds carry with them the most risk. In the case of the bank or mortgage lender the yield usually is more than the normal corporate bond and for the most part the risk is only if the lenders pay off the mortgages early thus lowering the interest.