Bonds from Government & Government-Related Sectors Explained | CFA Level I Fixed Income

In this lesson, we’ll provide a comprehensive understanding of government and government-related bond sectors. Let’s start with sovereign bonds.

Sovereign Bonds: The Basics

Sovereign bonds are issued by national governments or their treasuries and are backed by the government’s taxing power. Most governments issue bonds in their own currency, which usually have high credit ratings and are considered essentially free of default risk, thanks to their ability to collect taxes and print the currency.

Some countries issue bonds in foreign currencies to cater to demand from overseas investors or due to perceived high currency risk. These foreign currency bonds often have lower credit ratings because the government cannot print the foreign currency.

Types of Sovereign Bonds: Maturities & Features

There are various types of sovereign bonds based on their maturities:

• T-bills: less than 1-year maturity
• T-notes: between 1 to 10 years maturity
• T-bonds: greater than 10 years maturity

These bonds can be traded periodically, with the most recently issued bonds referred to as “on-the-run” bonds, which serve as benchmark issues for other bonds with similar characteristics.

Interest Provisions: T-bills vs. T-notes and T-bonds

There is a difference between money market securities like T-bills (pure discount bonds) and capital market securities such as T-notes and T-bonds (coupon bonds with a bullet structure). T-bills are issued at a discount to par value and redeemed at par, while T-notes and T-bonds make semi-annual coupon payments.

Floating Rate Bonds: A Response to Interest Rate Risk

Some governments issue floating rate bonds, which have less interest rate risk but less certain cash flows. These bonds have their interest rates tied to a reference rate. The US began issuing floating-rate bonds in 2014.

Inflation-Linked Bonds: Addressing Inflation Risk

To address inflation risk, governments issue inflation-linked bonds, such as the US Treasury Inflation-Protected Securities (TIPS), where coupon payments or principal repayments are linked to an index of consumer prices. This helps to protect investors from the eroding purchasing power of fixed cash flows due to inflation.

Non-Sovereign Bonds: Local Government Bonds

Non-sovereign bonds are issued by states, provinces, or counties to fund local budgets or projects. These bonds may be supported by project revenues, special taxes, or local general taxes, and their credit ratings can vary widely. US municipal bonds are an example of non-sovereign bonds. The credit quality of these bonds also depends on the level of guarantee or funding commitment from the national government.

Agency or Quasi-Government Bonds: Supporting Specific Purposes

Agency or quasi-government bonds are issued by entities created by national governments for specific purposes, such as financing small businesses or providing mortgage financing. The US Federal National Mortgage Association (Fannie Mae) is a good example of a quasi-government entity that issues agency bonds. These bonds are usually rated high due to low historical default rates and may be backed by collateral or the national government.

Supranational Bonds: Funding Multilateral Agencies

Lastly, supranational bonds are issued by supranational agencies, also known as multilateral agencies. These are not governments and do not have tax revenue, so they rely on donations, investment income, and loan income to make payments to bondholders.

Supranational bonds typically have high credit quality and can be very liquid, especially for large issues from well-known entities. Examples of supranational organizations issuing bonds include the World Bank, the International Monetary Fund (IMF), and the Asian Development Bank.

Conclusion

To sum up, bonds from government and government-related sectors come in various forms. Sovereign bonds, like US T-bills and T-notes, are backed by national governments and considered to be of the highest credit quality. Non-sovereign bonds, agency bonds, and supranational bonds have different levels of credit quality and serve distinct purposes, but they all play a crucial role in the fixed income market.