Art of default-free investment – Introduction to Government Bonds

Pretty sure many of you are confused after reading the title of the article. After all, there is no such thing as a “free lunch” in today’s world. Many of you who have taken part in some sort of a business venture and borrowed some money from a bank, understand that you may or may not be able to payback the loan. However, some of the smart ones reading this article know that lending to large corporation is considerably safer than lending to your local Chai-Wala. Not only will you face the risk of him running away with your cash, but he may not invest it prudently so as to repay your money. Hopefully, this will not be the case when it comes to loaning your money out the government (although you never know!).

This brings us to the gist of our topic for today: what exactly are government bonds and how safe are they? Governments all over the world raise money in various different ways to plug the gap in their budgets. In short, what would you do if you earn 30k a month and need a car worth 300k? You would most likely go and borrow money from a bank and mortgage the car. Similarly, governments borrow money from individuals like you and me, in order to build a project.  Just as we have to pay interest (or profit in the case of Islamic banks), governments pay us an amount in return for borrowing money from us. So, the next time you see a large hole dug up in the middle of nowhere for an underpass, that might be your money well spent!

Several banks around the world closed down and many people, who invested in these supposedly “safe banks,” lost billions of dollars during the crises. If our government faced a similar situation, it would most likely print some more money or borrow some cash from other banks or our best friend IMF. In simple terms, you will most likely get your money back. Moreover, government bonds are “backed” by the government. Meaning, government will do everything to payback the investors.

So, let’s begin exploring this investment alternative in some detail. Before we begin let me translate some of the Chinese our finance professionals use to describe this investment alternative.

Decoding Bond Jargons

Here are some of the terms that you might find on a website listing the details of Pakistan’s bonds:

Real-life example of a Pakistan’s Government Bond

Now that you have a basic understanding of the terms used to describe a bond, let me introduce a real-life bond issues by the government of Pakistan:

As the table shows, the bond can be bought at USD 113.28 and pays a coupon of 12% for the face value. Note that since the yield is below 12%, the price of the bond is above the face value. That is, this bond pays a higher coupon than other bonds and an investor who wishes to buy it will have to pay a higher price for it. Also note that its price has gone up by 23% over the last year, and it expires in 2022, at which time you will receive the face value of the bond.

Also see our next article on Pakistan’s bonds and how to invest in them.

Benefits of Investing in Bonds

  • Safe investment – Bonds are a safe investment since most governments have huge cash reserves along with the capability to raise or print money if needed. This is in contrast to the stock market or mutual funds that may rise or fall in value and diminish the value of your investment. If a Mutual fund goes bankrupt, you might end up receiving nothing
  • Good investment for risk averse investors – Bonds are a good investment for people who do not wish to take on too much risk, such as first timers or retirees. Plus, you also receive a payment every now and then. Not a bad investment, is it?
  • Fixed income – Unlike stocks and mutual funds, you know what you will receive after a particular period. In good times stock and mutual funds might perform fairly well; however, just as we witnessed over the last year, these financial instruments might go south very quickly indeed. With Bonds there is no potential for heavy gains or losses; however, they provide you with the stability required in tough times
  • Diversify the risk of your portfolio – just as we saw in our article on Mutual Funds, funds with a low-risk profile often invested most of their money in government bonds. This allowed them to perform better than the high-risk funds that invested primarily in the stock market. Thus, investors can invest in bonds and stocks to reduce the overall risk of their portfolios
  • High liquidity – Pakistan has a highly liquid bond market that allows investors to buy and sell bonds at the price quoted in the market

Drawbacks of Investing in Bonds

  • Long term investments – Yes, unlike investors of Bitcoin, you will not become an overnight millionaire by investing in bonds! Bonds are usually held by investors for a time frame of 3 to 5 years in order to maximize return. So fellas, buy some of these, and just forget about them for a while!
  • Low return – incase if you are wondering this is too good to be true, you are probably right. Despite being safe investments, bonds usually provide a somewhat lower rate of return. This is one of the reasons why we have to hold it for a longer time frame
  • No upward potential – despite stable income being one of its most important features, it provides no reward in times when market is on an upward trajectory. Stocks, cryptos and other risky assets can go up significantly; however, with bonds you basically get the same return over and over again. Boring isn’t it?
  • Inflation risk – if you are an investor who simply wants to buy some of these and hold it for the next 5-10 years, you might suffer from inflation risk. Your bond will basically pay the same coupon each year but the price of goods may increase significantly. For example, if your bond pays Rs. 12 each year, you can use this amount to buy 1 KitKat. However, the price of KitKat will be much higher 5 years from now, especially in a country such as Pakistan that has experienced significant amount of inflation over the last decade. Hence, your bond will continue to pay Rs. 12 but you will no longer be able afford that chocolate. Time to buy a local chocolate perhaps!

Conclusion

Government Bonds are an extremely useful investment instrument that can be used to provide a steady flow of income without taking on too much of a risk. However, despite all its advantages, the potential for higher gains is limited. As your financial advisors, we would recommend that investors use this investment alternative for reducing the overall risk of their portfolios and mix them with high-risk assets. Always remember; when the storm hits the ship, it’s the dinghy that saves people.