Disadvantages of Government Bonds

Issuing bonds is a way for the government to borrow money for its operations. When investors buy a government bond, they lend money to the government in exchange for interest payments and the return of their principal. U.S. Government bonds are in high demand due to the guarantee of payment that comes with them. There are some disadvantages, however, both for the issuer and the buyer of government bonds.

The main negative for the government when it issues bonds is that it takes on more debt. Rather than relying on taxes or other sources of revenue, by issuing bonds the government has an obligation to return payment plus interest to investors. Imagine if you had to finance your daily expenditures by borrowing on your credit card every month. While this might be a helpful short-term fix, in the long run you'll end up paying more than if you could have balanced your income and daily expenditures. The same higher costs hit the government when it borrows via the issuance of bonds. As a result, the government typically pays hundreds of billions of dollars of interest every year on its outstanding debt.

For an investor, U.S. government bonds are among the lowest-paying investments you can buy. The investment world is structured so that the more risk you take, the more the issuer has to compensate you for that risk in the form of higher interest payments. Since it is considered extremely unlikely that the U.S. government will not pay back its debts, it doesn't have to pay as much interest as other issuers.

While U.S. government bonds are considered safe in terms of repayment risk, they carry the interest-rate risk that afflicts all bonds. Interest-rate risk is the risk that your bond will fall in value after you buy it based on the movement of market interest rates. When interest rates rise, bond prices fall. If you hold your government bond until its maturity date, or the date when the government pays your money back, you can avoid interest-rate risk. However, if you want or need to sell your bond before that date, the value of your bond will fluctuate, and it may be worth less than when you bought it. Since government bonds can be 30 years in duration, there's certainly a chance you'll sell it before it matures, in which case interest rate risk will come into play.

The interest the government pays you on a bond is federally taxable. If you're in a high tax bracket, that can effectively reduce the already low interest rate you're likely earning even further. For example, if your government bond is paying 1.66 percent and you're in the top 39.6 percent federal tax bracket, your effective after-tax rate is just 1 percent.