Advantages & Disadvantages of Government Bonds

Government bonds are fixed-income debt securities that allow federal, state and local governments to raise capital to accomplish critical projects. Types of bonds issued by the government include Treasury Bonds, Treasury Bills, Treasury Notes, municipal bonds, savings bonds, floating rate notes and zero-coupon bonds. Corporate bonds may offer higher interest rates and yields, but they tend to have more volatility than government-issued bonds. As with any investment, there are advantages and disadvantages of bonds issued by the government.

NPR explains that government bonds have a long-held reputation of being low-risk and low-reward. But some benefits make these types of investments suitable for asset allocation and portfolio diversification.

The most significant risk you face as a bondholder is that the bond issuer will default on its obligation. If this happens, you won't continue getting interest payments, and your bond won't reach maturity.

Government bonds are traditionally a safer bet than corporate bonds issued by companies. Government securities are backed by the government and many offer guaranteed returns. For instance, TreasuryDirect says the U.S. EE savings bond is guaranteed to double in ‌20 years‌ when held as a long-term bond. Short-term Treasury Bills (T-Bills) are sold below face value, and the government guarantees to pay you face value at maturity.

It's rare that a local, state or federal government would be a credit risk or default on bonds. In 2022, credit rating agencies Standard and Poor's and Fitch Group rated the U.S. government at AA+ and AAA, respectively. In contrast, some corporations that issue bonds may experience a declining credit rating, declare bankruptcy and default on obligations.

With most bonds, you're subject to state and federal income tax on interest income you receive from bond coupons. However, depending on the type of bond, a government-issued bond may be exempt from some taxes.

Interest income on municipal bonds from the state you live in may be exempt from federal, state and local taxes. According to the IRS, U.S. savings bonds are exempt from state and local income tax, and federal taxes can be deferred until the bonds are redeemed.

If you own a bond fund, money market or ETF (exchange-traded fund) partially composed of government securities, you may find related tax benefits by consulting with the IRS and your financial advisor.

According to the U.S. Department of the Treasury, most Treasury securities are highly liquid and can quickly be sold for cash before their maturity date. Bondholders must work with a bank, broker or dealer to sell Treasury marketable securities on the secondary market.

While all bond prices can be sensitive to the economy, the government bond market generally tends to be more resilient. Increased liquidity of an investment can be a positive attribute for both cash flow and personal finances.

When you buy bonds from the local, state or federal government, the funds support government projects. Municipal bonds are issued by city and county governments, and these bonds fund public works projects like schools, highways and hospitals. This makes purchasing municipal bonds an attractive option for investors who want funds to stay in their state or local community.

Government bonds' security, liquidity and tax benefits do not come without their flip side.

Risk and rate of return have an inverse relationship when it comes to investing. Because of the high credit rating and low risk of default with government bonds, the yield rate also tends to be low. If the bond isn't inflation-protected security, it's possible that it won't even beat the inflation rate.

A potential investor can check the current interest rate on TreasuryDirect.gov and the current inflation rate or Consumer Price Index (CPI) on the Bureau of Labor Statistics website.

In contrast, high-yield stock market investments historically have the potential to bring higher returns.

When you purchase a bond, you're locking in an interest rate for 10, 20 or even 30 years. If interest rates suddenly rise dramatically, you're stuck with an investment paying an interest rate below market value. In turn, this decreases the market value of your bond.

This may not matter if you hold the bond to its maturity date – since you'll receive the par value when it matures – but it means the individual bond won't go for much if you try to sell it before maturity on the secondary market.

While Treasury Bills or zero coupon bonds can be purchased at a price below face value, an investor can get surprised with capital gains taxes and ordinary income taxes on the difference between par value and the price paid, warns Charles Schwab. While that may not outweigh the benefits of other tax advantages or the portfolio diversification offered by municipal bonds, it is essential to take into consideration.