If the U.S. Government bonds guarantee to pay interest, where would any potential risk come from? Won't the h

Question

This is an I am studying (government bonds) and I am a bit confused.

Sorry last part didn't type out right. The second part of the question was:

Won't the holder of the bond receive his or her interest?

Answer 1

The risk is the price you could get if you want to sell the bond could be less than you paid for it if interest rates rise.

If you paid $1000 for a bond paying 5% and the want to sell it, if interest rates went up to 6%, people would want to earn 6% on any bond they would buy so they would pay only $833.33 for the bond. Then, when it pays $50 ( 5% of the $1000 face value) they get 6% of what they paid (0.06x833.33). If you wanted to sell it, then you have a loss of 1000-833.33= 166.66.

Of course, if you held it to maturity, you would not have this problem because you would always be getting your 5% and then you get $1000 back at the end.

So, what is the big gig? Well, if an individual like you and I buy a bond that pays 5% for 10 years, we are happy with that, although, if rates go up, we might be kicking ourselves for not waiting for the rise. However, money managers don't have that option. If rates go up to 6%, the people paying the managers get real mad if they are getting only 5%. After all, what are the managers getting the BIG BUCKS for? So, the managers can't hold a lot of "below current rate" bonds. They are always trading stocks and bonds thus they are exposed to this risk of lower selling price when rates rise.

Note, if rates go down, you can get more for your bond for the same reasons.

Hope this helps.

Answer 2

The people above have done a pretty thorough job and left little else to add. Anyway, these are some of the "left overs" I've found:

There are several types of risks, being credit and market risks the two most important. There are several others, but I think that, in this case, the third most important would be liquidity risk.

As the people above already said, the chance of a Dolar denominated Treasury bond not being payed (the credit risk) is almost none because, even if the government didn't have money, they could eventually get aproval to issue more money to pay off its debt. (Of course that this entails in some of the problems and ririsks mentioned above: inflation and higer rates).

The hiegher rate risks (known as market risk) was pretty well covered by everyone else, but Peter C may have made a misleading coment in relation to fund managers. If you put your money in a fund that buys fixed income assets and there is an interest rate increase, the assets that the fund has in its portfolio will have its value decreased. Because the funds must mark-to-market each of the assets in the portifolio, the value of you stake will actually drop (unless they are using derivatives to protect from this). This is far worse that simply not getting the higher rates.

The liquidity risk occurs if you buy a T-bond that has a lower that is not traded very frequently and have to get rid of it fast, you might have to sell it for slightly less than its fair market value. Actually, this is not a very realistic description of what really happens because you have market makers that have already established a "fair" value and will buy it for that value and if you bought it for less, then the resale value will not incorporate this loss. However, if you bought it at issue, it is an "on-the-run" bond aand will suffer a drop as soon as another maturity date becomes that on-the-run bond.

Answer 3

Please don't feel stupid, cuz its a hard subject. But like the above guy says, the risk of not getting your interest from the gov. is very small, hence the low interest rate (but gov have gone bankrupt before). But there are other risks involved when considering bonds. These risks include but are not limited to;

-a decline in the dollars value (making the dollars you get back more worthless)

Same as with inflation (if inflation is 3% and your interest rate is 5% you really are only getting 2%) T

The interest rate risk-newer bonds are offering higher interest rates
Then there is the risk of better investments(opportunity? risk)-like if you give US Jane money at 5% interest and she is very reliable, but you could have given Jazzie Jackie the same money at 10% interest with a pretty good possibably of getting it back, then there was risk that you could have got more interest for your money-the extra 5%.

I am sure I'm not covering them all, but hopefully I didn't confuse you more and made it a little more understandable....it's a hard subject ;-)

Answer 4

Risk comes from several sources.

1. chance of default. Governments have been known to default on their bonds. City of New York did. State of Washington did.

2. chance of rising interest rates. That will cause the value of the bonds to drop. For example in 1980, 5% 30 year government bonds dropped to 30c on the dollar as interest rates went to 12%.

3. Drop in the value of the dollar again world currencies. As the dollar looses value agains other currencies, your purchasing power of dollar denominated bond drops.

4. Inflation. What will the dollar be worth 30 years from now when the bonds come due? Worth about 20c in todays dollars.

Answer 5

The risk is earned income related to taxes and inflation. In California, the inflation rate is 5%, so you are automatically losing worth on any bond less than 5%. Not only that, you lose more worth when you sell (unless the bond is in a Roth) and pay taxes on it. The bond is guarented to do what they say it's going to do, even to the point where they just print more money to pay it off (a common thing done in Latin America).

Answer 6

the real question isn't if, but when the US will default. As Communist China is the largest holder of these bonds, defaulting for some engineered reason would deal a huge blow to the Commie Core.
Remember our money used to be backed by gold and silver. Now it is backed by the full faith and credit of a highly corrupt government. Just wait until you see the new barter currency. Imagine if instead of tying up the currency to metal or faith, we pinned it to the average of all things tradeable.

Answer 7

the fact that it's the US government issuing the bonds makes them pretty safe. Potential risks would involve anything that might cause the federal government to default on payments including collapse of the US economy, catastrophic events like being hit by a meteor, tsumanis, thermonuclear war, etc. These are unlikely events but then so was the collapse of the world trade center.

Answer 8

The holders will get their interest. The US govt. is biggest economic power,
so it will give the interest. However, there is always a very little chance of default due to total collapse of the Government which seems to be very
far-fetched doom and gloom scenario.