A government bond is a loan you make to a government, and the government pays you back with interest

When you buy a government bond, you are lending money to a federal, state, or local government. The government promises to pay you back the full amount on a specific date, called the maturity date, and to pay you interest along the way. The interest rate is set when the bond is issued and does not change. You can hold the bond until maturity and collect the full amount, or you can sell it to someone else before that date — though the price you get depends on interest rates and market conditions at the time you sell.

Government bonds are considered safer than most other investments because governments have the power to tax and, in the case of federal bonds, to print money. That safety comes with a trade-off: the interest rate on government bonds is usually lower than what you could earn from stocks or corporate bonds. People buy them anyway because they want predictable income, a place to park money they will need at a specific time, or a way to reduce risk in a mixed investment portfolio.

Key Takeaways

  • A government bond is a debt security where you lend money to a government and receive regular interest payments plus your principal back at maturity.
  • Federal bonds are issued by the U.S. Treasury in three main forms: Treasury bills (under one year), Treasury notes (two to ten years), and Treasury bonds (20 to 30 years).
  • State and local governments issue bonds to fund schools, roads, and other infrastructure, and the interest you earn on many of these bonds is not subject to federal income tax.
  • You can buy government bonds directly from the government, through a bank or broker, or as part of a mutual fund or bond fund.
  • The price of a bond falls when interest rates rise and rises when interest rates fall, so selling before maturity can result in a gain or loss.

How the U.S. Treasury issues bonds

The federal government issues three types of bonds through the U.S. Treasury. Treasury bills mature in less than one year and are sold at a discount — you pay less than the face value upfront and receive the full face value at maturity, with the difference being your interest. Treasury notes mature in two, three, five, seven, or ten years and pay interest twice a year. Treasury bonds mature in 20 or 30 years and also pay interest twice yearly.

You can buy Treasury securities directly from the government through TreasuryDirect, a website run by the U.S. Department of the Treasury. You set up an account, fund it with money from a bank account, and place bids in auctions held regularly for each type of security. You can also buy them through a bank, brokerage firm, or financial advisor, though you will typically pay a fee for that service. The minimum purchase through TreasuryDirect is $100 for most securities.

The interest rate on Treasury securities is determined by auction. The government announces how much it wants to borrow, investors submit bids saying what interest rate they will accept, and the Treasury accepts bids from lowest interest rate to highest until it has borrowed the amount it needs. This means the interest rate changes with each auction and reflects what investors think about the economy and inflation at that moment.

State and local government bonds and tax advantages

States, cities, and counties issue bonds to pay for schools, roads, water systems, and other infrastructure projects. These are called municipal bonds or "munis." The interest you earn on most municipal bonds is not subject to federal income tax, and if you buy a bond issued by your home state, the interest is usually not subject to state income tax either. This tax advantage makes municipal bonds attractive to people in higher tax brackets, even though the interest rate is typically lower than what you would earn on a taxable bond.

Municipal bonds come in two main types. General obligation bonds are backed by the government's power to tax — the government promises to use tax revenue to pay you back. Revenue bonds are backed by income from a specific project, like tolls on a highway or fees from a water utility. Revenue bonds carry more risk because if the project does not generate enough income, the government may not have the money to pay you.

You can buy municipal bonds through a broker or financial advisor. The minimum purchase is often $5,000, though some brokers allow smaller purchases. You can also buy them through a municipal bond mutual fund or exchange-traded fund, which pools money from many investors and holds a diversified collection of bonds.

What happens to bond prices when interest rates change

If you hold a bond until maturity, you will receive the full face value no matter what happens to interest rates. But if you need to sell before maturity, the price you receive depends on how current interest rates compare to the interest rate on your bond. When interest rates rise, existing bonds become less attractive because new bonds pay more interest, so the price of your bond falls. When interest rates fall, existing bonds become more attractive because new bonds pay less interest, so the price of your bond rises.

The longer the time until a bond matures, the more its price will move when interest rates change. A 30-year Treasury bond will swing in price much more than a one-year Treasury bill if interest rates move by the same amount. This is why longer-term bonds are considered riskier if you might need to sell before maturity — you could be forced to sell at a loss if interest rates have risen since you bought the bond.

This price movement is one reason people hold bonds in a portfolio alongside stocks. When stock prices fall during economic uncertainty, interest rates often fall too, which pushes bond prices up. This offsetting movement can reduce the overall swings in a portfolio's value.

How to buy government bonds and where to hold them

For federal Treasury securities, the simplest route is TreasuryDirect. You create an account online, link a bank account, and bid in auctions. You can set up automatic reinvestment so that when a bond matures, the money is used to buy a new one. There are no fees, and you hold the bonds in an account with the U.S. Treasury.

If you want to buy and sell bonds more frequently, or if you want a mix of Treasury, municipal, and corporate bonds, a brokerage account gives you more flexibility. You can open one at firms like Fidelity, Vanguard, Charles Schwab, or many others. You will pay a commission or fee per trade, though some brokers have reduced or eliminated fees for certain securities. You can also buy bond mutual funds or exchange-traded funds through a brokerage account, which gives you instant diversification across many bonds.

For tax-advantaged municipal bonds, working with a financial advisor or broker who specializes in munis can help you understand the tax benefits and find bonds that match your time horizon and risk tolerance. If you are in a lower tax bracket, the tax advantage may not be worth the lower interest rate, and a taxable bond might be the better choice.

The risks of buying government bonds

Interest rate risk is the main risk for bond investors. If you sell before maturity and interest rates have risen, you will receive less than you paid. Inflation risk is another concern — if inflation rises faster than your bond's interest rate, the money you get back will buy less than it does today. A bond paying 2 percent interest loses purchasing power if inflation is 4 percent.

For municipal bonds, there is also credit risk — the risk that the government issuing the bond will not have the money to pay you back. This is rare for general obligation bonds backed by a large city or state, but it is a real concern for revenue bonds or bonds issued by smaller or financially stressed municipalities. Before buying a municipal bond, you can check its credit rating from agencies like Moody's or Standard & Poor's.

Federal Treasury securities carry virtually no credit risk because the U.S. government has never defaulted on its debt. However, they are still subject to interest rate risk and inflation risk. During periods of rising interest rates or high inflation, Treasury bonds can lose value if you need to sell before maturity.

Frequently Asked Questions

Can I lose money on a government bond?

If you hold the bond until maturity, you will receive the full face value and will not lose money. If you sell before maturity and interest rates have risen, the price you receive will be less than what you paid, resulting in a loss. Federal Treasury bonds carry almost no risk of default, but municipal bonds from financially weak governments do carry some credit risk.

How much interest will I earn on a government bond?

The interest rate depends on the type of bond, how long until it matures, and current market conditions. Treasury bills currently pay less than Treasury notes, which pay less than Treasury bonds. Municipal bonds typically pay less than Treasury bonds of the same maturity because of the tax advantage. You can see current rates on TreasuryDirect or through any broker.

What is the difference between a Treasury bond and a Treasury note?

Treasury notes mature in two to ten years, while Treasury bonds mature in 20 or 30 years. Both pay interest twice a year. The longer maturity of Treasury bonds means their prices swing more when interest rates change, so they carry more interest rate risk if you need to sell before maturity.

Should I buy individual bonds or a bond fund?

Individual bonds are simpler if you want to hold until maturity and do not need to sell early. Bond funds offer instant diversification and professional management, but they charge fees and do not have a maturity date — the fund's value changes with interest rates. For most people, a low-cost bond fund or Treasury fund is easier to manage than buying individual bonds.

Are government bonds a good investment right now?

That depends on your goals, time horizon, and what else you own. Bonds provide stable income and reduce portfolio risk, but they pay less than stocks historically do over long periods. If you need money in a few years or want to reduce risk in a stock-heavy portfolio, bonds may make sense. A financial advisor can help you decide what mix is right for your situation.