Pros & Cons of Government Bonds

Government bonds include bonds issued by federal agencies, such as the U.S. Department of the Treasury, and municipal bonds, which are issued by state and local governments and school districts. Government agencies cannot issue stock to meet funding shortfalls, which leaves debt financing as their only option to raise money for essential services and long-term capital projects, such as bridges, hospitals and schools. Because they tend to carry less repayment risk than bonds issued by private firms, government bonds are typically an important component of individual and institutional investment portfolios who rely on them for security and stability.

Government bonds are generally considered at low risk of default compared to other securities, such as stocks and corporate bonds. Government bonds are well suited for balanced and conservative investment portfolios because they provide both safety of principal and regular interest income. Investors can use bonds of different maturities and from different issuers to achieve high rates of return, while retaining flexibility. Government bonds are liquid and trade in the over-the-counter bond market. Investors can buy Treasury bills, notes and bonds directly from the Treasury department's TreasuryDirect website in denominations as low as $50.

Government bonds also have certain tax advantages, depending on their issuing agency and, to an extent, on the type of bonds they are. For example, interest payments on U.S. Treasury bonds are exempt from state and local taxes, but are subject to federal taxes. Interest payments on general obligation municipal bonds -- bonds that are backed by the issuing agency's general taxing authority -- are exempt from federal taxes and even from state and local taxes inside the state or jurisdiction that issues them. On the other hand, revenue bonds -- local government bonds that are backed by the income that a project is expected to produce, such as a hospital, a stadium or a business improvement district -- may be subject to some taxation.

Government bonds generally involve little to no risk of default. But, just as any other bonds traded in the open market, government bonds may lose value if their market interest rates rise beyond the bonds' face value. This is because bond prices move in the opposite direction from interest rates: when market interest rates rise, the price of existing bonds drops, and vice versa.

U.S. Treasury bonds are generally considered to be free from default risk altogether, since the U.S. government -- with its ability to create dollars at will -- backs them. Municipal defaults are highly rare, but they do happen. Two well-publicized examples include Orange County, Calif., in 1994 and Harrisburg, Pa., in 2011. As with private corporations, when governments default, their bondholders can expect to lose some -- if not all -- of their principal. Because of this, local and state governments that are considered to be in weaker economic circumstances are typically forced to pay higher interest rates to attract investors.