Government bonds: Why are they so important in financial markets and why are they so high now?

Nick Sundich Nick Sundich, October 25, 2023

Most investors will have heard of government bonds and know that they are important to financial markets. But not all investors will know why they are so important and why they fluctuate all the time. We will seek to answer these questions here.

 

What are government bonds?

Government bonds, also known as treasury bonds or treasuries, are debt securities issued by a government to finance its operations. They are considered one of the safest investments available and are therefore a prominent feature in financial markets. The most prominant is the US 10 year treasury bond. It is issued by the US Treasury Department on behalf of the US government to fund its operations and projects.

This bond is considered as one of the most important and influential in the world due to its role in global financial markets. It is used as a benchmark to determine interest rates for other financial products such as mortgages and corporate bonds. And at Stocks Down Under, we use this as an input to our costs of capital whenever valuing international companies.

 

Safe haven

Investing in US 10 year treasury bond is seen as the ultimate safe investment option due to the creditworthiness of the US government and its ability to repay the individual bonds (even if it has an inability to stop its total balance from continuing to expand). However, it also comes with lower returns compared to riskier investments.

The main reason for the popularity of government bonds is that they are backed by the full faith and credit of the government issuing them. This means that investors have a high level of confidence in receiving their principal investment amount back, along with the promised interest payments. While the 10-year government bond is most standard, some are shorter term (i.e. less than a year) while others expand several decades. Generally, the longer the maturity, the higher the interest rate offered.

You can find the rates of government bonds on news sites like Bloomberg and Yahoo.

 

The role of government bonds in Financial Markets

Government bonds play a critical role in financial markets as they provide a benchmark for other fixed-income securities, such as corporate bonds and mortgage-backed securities. They also serve as a safe haven asset during times of economic uncertainty, as investors seek to protect their investments in highly volatile markets.

The issuance and trading of government bonds can also have an impact on interest rates. When there is a high demand for government bonds, the price increases, and consequently, the yield decreases. This leads to lower interest rates for other types of debt in the market. On the other hand, if there is a decline in demand for government bonds, interest rates for other types of debt may increase.

 

Why are government bonds on the rise right now?

The famous 10-year US Treasury yield has hit 5% for the first time since 2007. And the Australian 10-year bond is not far behind at 4.8%. Bonds such as these are high because they are appearing the only genuine safe haven from inflation. Interest rates have been rising for over 18 months but inflation remains stubbornly high. Demand for safe haven assets have continued to drive bonds higher.

For much of the last 18 months, investors may have accepted rising interest rates as inevitable, but thought that they would work in bringing inflation down, that interest rates would gradually fall in 2024 or both. Neither is true and bond rates will remain high until inflation reaches its more normal range of 2-3%.

 

US 10-year treasury, log scale (Source: TradingView)

 

Conclusion

In conclusion, government bonds are an essential component of financial markets. Their safety and stability make them appealing to investors and set the benchmark for other fixed-income securities. They also have a significant impact on interest rates, making them closely monitored by economists and financial analysts.

So, it is no surprise that government bonds remain a prominent feature in financial markets worldwide. So, keep an eye on them when considering your investment portfolio.

 

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