Government bonds are a type of investment that allow you to make money by essentially lending money to the local, state or federal government. They're considered to be relatively safe investments, since governments seldom default on their debts, and they can also have tax advantages over other types of investments. A potential disadvantage is that they usually don't deliver returns as high as riskier types of investments.
How Bonds Work
A bond is a type of security that represents debt. When a bond is sold by a company or a government agency, investors are effectively giving the issuing organization a loan that is paid back over time with interest. Like stocks, bonds can be bought and sold by multiple investors over their lifetimes. They usually have a fixed time until they finish paying back the money, or mature.
Bonds issued by the federal government are known as Treasury bonds, after the federal Treasury Department that issues them, and those issued by state and local agencies are often called municipal bonds.
Bonds typically have credit ratings that represent the risk involved in buying them. Those that carry more risk will typically pay more interest, but there's always a danger that investors will lose money if the issuing entity is unable to pay its debt. Bonds rated below a certain threshold are known as junk bonds.
Government Bonds Advantages and Disadvantages
If you're thinking about Treasury bonds advantages and disadvantages, one of the biggest pluses is the relative lack of risk. U.S. Treasury bonds are often considered the safest investment in the world, treated as essentially risk-free, although it's not inconceivable that the United States could one day default on its debts. Putting money into Treasury bonds can be a good option for cash that you can't afford to lose.
Municipal bonds aren't quite as safe as Treasury bonds, and risk can vary from agency to agency, but they are also considered to be safe investments. Make sure you evaluate the agency issuing any bonds and consult any information available about the investment before you put money into bonds or any other securities.
Another big advantage of government bonds is how they're treated for tax purposes. Interest that you earn on federal Treasury bonds isn't subject to state or local income tax, and interest on municipal bonds isn't subject to federal income tax. Many states also exempt municipal bonds issued in their states from state and local income tax, which can be a factor when you're deciding which bonds to buy along with the municipal bonds' rates.
The main disadvantage of government bonds compared to stocks and some other investments is the relatively low return. You can often make more money investing in the stock market, real estate or other opportunities than buying and holding government bonds, but if you are nearing retirement or otherwise want a safe place to stash some of your funds, government bonds can be a good option.
Buying Government Bonds
You can buy Treasury bonds directly from the government through the TreasuryDirect online system or, if you prefer, by working with a bank or brokerage of your choice. You may pay a fee if you work with a broker.
For municipal bonds, you'll typically want to work with a bank or brokerage to buy the bonds you wish. Some may provide advice on developing a good portfolio of bonds, or you can do your own research and buy bonds directly through your broker's online trading system.
If you don't want to own bonds directly, you can also invest in a mutual fund or exchange-traded fund that invests in bonds. Work with the company that operates the fund or, in the case of an exchange-traded fund, put money into the fund through any broker of your choice. Make sure you understand the fees charged and how the fund makes its investment decisions.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.