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. That interest is your return for letting the government use your money.
The U.S. federal government issues bonds to pay for roads, military spending, interest on existing debt, and other operations. States and cities issue bonds to pay for schools, water systems, and public buildings. Because governments are backed by tax revenue and have rarely defaulted on their debts, bonds are considered one of the safest investments available — but they also pay less interest than riskier investments like stocks.
You do not have to hold a bond until maturity. You can sell it to someone else before the maturity date, though the price you get depends on interest rates and how much time is left. If interest rates have risen since you bought the bond, you will have to sell it for less than you paid. If rates have fallen, you can sell it for more.
Key Takeaways
- A government bond is a debt security where you lend money to a government and receive interest payments until the bond matures.
- Federal bonds (Treasury bills, notes, and bonds) are issued by the U.S. Department of the Treasury and backed by the full faith and credit of the federal government.
- Municipal bonds issued by states and cities often have tax advantages — the interest is usually not taxed by the federal government, and sometimes not by your state either.
- Bond prices move in the opposite direction of interest rates: when rates go up, existing bond prices fall, and when rates go down, existing bond prices rise.
- You can buy government bonds directly from the government or through a bank or brokerage, and you can sell them before maturity if you need the money.
The three types of U.S. Treasury bonds and how long you hold them
The federal government issues three main types of bonds, each with a different maturity date. Treasury bills mature in one year or less. Treasury notes mature in two to ten years. Treasury bonds mature in twenty or thirty years. The longer you agree to lend your money, the higher the interest rate the government pays you, because you are giving up access to that money for a longer time.
All three are issued by the U.S. Department of the Treasury and backed by the federal government's ability to collect taxes. You can buy them directly from the Treasury through a website called TreasuryDirect, or you can buy them through a bank or brokerage. If you buy through a bank or brokerage, you may pay a fee, but you get access to a wider range of bonds and can sell them more easily if you need to.
Interest on federal bonds is taxed by the federal government but not by most states. This makes them attractive to people in high-tax states, though the tax advantage is small compared to the interest rate difference between bonds and other investments.
Municipal bonds and the tax break for state and local debt
States and cities issue municipal bonds to raise money for schools, highways, water systems, and public buildings. The interest you earn on most municipal bonds is not taxed by the federal government, and often not taxed by your state either if you live in the state that issued the bond. This tax break makes municipal bonds attractive to people in high tax brackets, even though they usually pay lower interest rates than federal bonds.
Not all municipal bonds have the tax break. Revenue bonds are backed by the income from a specific project — like tolls from a highway or fees from a water system — and their interest is usually taxed. General obligation bonds are backed by the government's power to tax, and their interest is usually not taxed. Before you buy a municipal bond, check whether the interest is taxable or not.
Municipal bonds carry more risk than federal bonds because cities and states can struggle financially. If a city cannot collect enough tax revenue, it may not be able to pay you back. Rating agencies like Moody's and Standard & Poor's rate municipal bonds to show how likely the issuer is to pay. A higher rating means lower risk and lower interest, while a lower rating means higher risk and higher interest.
How interest rates affect the price you pay or receive when selling
Bond prices and interest rates move in opposite directions. When the Federal Reserve raises interest rates, new bonds issued by the government pay higher interest. If you own an older bond that pays lower interest, it becomes less attractive to buyers, so its price falls. If you need to sell before maturity, you have to accept a lower price to make up for the lower interest rate.
The opposite happens when interest rates fall. New bonds pay lower interest, so your older bond that pays higher interest becomes more attractive. Its price rises, and you can sell it for more than you paid. This is why people who think interest rates will fall sometimes buy bonds — they expect to sell them at a profit before maturity.
The longer the bond's maturity, the bigger the price swing when interest rates change. A thirty-year Treasury bond's price will move much more than a two-year note when rates shift. This is called duration risk, and it is why long-term bonds pay higher interest — you are taking on more risk that rates will move against you.
Where to buy government bonds and how much money you need
You can buy federal bonds directly from the U.S. Department of the Treasury through TreasuryDirect.gov. You need a bank account and a Social Security number or tax ID. Treasury bills, notes, and bonds can be purchased in amounts as small as one hundred dollars. You can set up an account in about fifteen minutes and buy bonds online.
You can also buy bonds through a bank or brokerage like Fidelity, Vanguard, or Charles Schwab. These firms usually charge a fee per transaction, but they offer a wider selection of bonds and make it easier to sell before maturity. Some brokerages waive fees if you hold the bond to maturity.
Municipal bonds are usually sold through brokerages, not directly from the issuer. Minimum purchases are often higher — sometimes five thousand dollars or more — and fees vary. Some brokerages specialize in municipal bonds and can help you find bonds issued by your state or city.
What happens when a bond reaches maturity
When a bond matures, the government pays you back the full amount you lent, called the principal. If you bought a bond for one thousand dollars, you receive one thousand dollars back. You also receive the final interest payment. The money arrives in your bank account within a few business days.
At that point, you have to decide what to do with the money. You can buy another bond, invest it elsewhere, or keep it in cash. If you bought the bond through TreasuryDirect, you can reinvest the proceeds into new bonds automatically, or you can let the money sit in your account until you decide what to do.
The difference between bonds and bond funds
A bond fund is a mutual fund or exchange-traded fund (ETF) that holds many bonds and lets you invest a small amount of money. Instead of buying individual bonds, you own a small piece of hundreds or thousands of bonds. Bond funds are easier to buy and sell, and they spread your risk across many issuers.
The trade-off is that bond funds do not have a maturity date. The fund manager buys and sells bonds constantly, so the value of your investment changes every day based on interest rates and the bonds in the fund. If interest rates rise, the fund's value falls, even though individual bonds in the fund will eventually mature at full value. Bond funds charge annual fees, usually between 0.05 and 0.50 percent of your investment.
Individual bonds are better if you want to know exactly when you will get your money back and you plan to hold until maturity. Bond funds are better if you want to invest a small amount, want professional management, or want to sell quickly without waiting for maturity.
Frequently Asked Questions
Can I lose money on a government bond?
If you hold a bond until maturity, you get back the full amount you lent, so you cannot lose money. If you sell before maturity, you may get less than you paid if interest rates have risen. The federal government has never defaulted on its bonds, so federal bonds are considered very safe. Municipal bonds carry more risk because cities and states can struggle financially, though defaults are rare.
How often do I get paid interest on a bond?
Most government bonds pay interest twice a year. Treasury bills pay interest once, at maturity. The interest payment dates are set when the bond is issued, so you know exactly when to expect money. If you sell the bond before the next interest payment, the buyer pays you the interest that has built up since the last payment.
What is the difference between a bond and a savings account?
A savings account is insured by the FDIC up to 250,000 dollars and you can withdraw money anytime, but it pays very low interest. A bond pays higher interest but your money is locked in until maturity, and if you sell early you may get less than you paid. Bonds are better for money you do not need for several years; savings accounts are better for emergency money.
Do I pay taxes on bond interest?
Interest on federal Treasury bonds is taxed by the federal government but not by most states. Interest on municipal bonds is usually not taxed by the federal government or your state, which is why they are attractive to high-income earners. You report all taxable interest on your tax return each year, even if you have not sold the bond yet.
What happens if I need my money before the bond matures?
You can sell the bond to someone else, but the price depends on current interest rates. If rates have risen, you will get less than you paid. If rates have fallen, you may get more. The sale takes a few business days to settle. Treasury bonds can be sold quickly through TreasuryDirect or a brokerage, but municipal bonds may take longer to find a buyer.