The investment world has many familiar and less familiar terms. For example, stocks, bonds and futures. But what exactly do they mean? In a series, we explain the characteristics and genesis of various asset categories. In this episode, Hans van Westrienen (Senior portfolio manager at APG) discusses what may be the safest form of investment: the government bond.
The government bond summarized
What is it?
A loan issued by a government.
When did it come into being?
In 2400 BC, in Mesopotamia. The oldest bond on which interest is still being paid dates from 1624 and belongs to a Dutch water company.
What else is involved?
A bond can be traded just like a stock. The value moves in opposition to the interest rate. That interest rate also depends on the creditworthiness of the government issuing the bond.
What is it?
“A government bond is really just a loan issued by a government,” Van Westrienen explains. “That loan usually involves a large amount, in some cases up to more than 10 billion euros, and is therefore divided into many smaller parts. By investing in one of those parts, big investors such as pension funds, lend money to the state. This makes them bondholders, and they will receive annual interest during the term of the bond. The purpose of such a bond is for a government, for example the Dutch state, to raise money. You can think of that government as a big corporation with income - mainly taxes - and expenses, such as social security, health care and education. Taxes don’t always come in when money is needed for spending, and sometimes a state wants to spend more than what comes in. By issuing state bonds, it raises the extra money needed.”
One way in which they differ from equities is that equities usually take only one form. “Government bonds come in different shapes and sizes, with maturity and interest rates varying from bond to bond. The simplest form is that a government issues bonds for 10 years, pays a fixed interest rate annually, and repays the borrowed amount to bondholders after those 10 years.”
The longest-running bond in the world is from 1624.
When did it come into being?
The oldest known bond dates to 2400 BC, chiseled into a stone discovered at Nippur, a site in what was then Mesopotamia (present-day Iraq).
The longest-running bond in the world is that of the Hoogheemraadschap De Stichtse Rijnlanden, from 1624. This is a perpetual loan with an interest rate of 2.5 percent, issued nearly four hundred years ago, so that the water board could finance the repair of a dike. The Stichtse Rijnlanden still pays annual interest to bondholders of six other centuries-old bonds or letters of interest.
The interest on a bond is also called coupon (interest). This term can be traced back to the fact that a bond used to consist of two large sheets. From one of those sheets, you would cut a coupon (annually) and hand it in to the bank, which would then pay you the interest.
What else is involved?
Like a stock, a bond can also be traded. “If investor A has purchased a bond from the Dutch state, he can sell that bond on the market to investor B. Then the state owes interest and the borrowed amount to investor B. If interest rates rise, the price of a bond falls - and vice versa. “Say the Dutch state issues a bond of 100 euros for 10 years with a coupon rate of 2 percent. A possible rise in interest rates to 4 percent makes this bond with a 2 percent coupon less attractive. A bondholder would rather receive a higher interest rate on the money lent. To compensate for this, the price of the bond drops to, say, 80 euros. In contrast, the coupon payment remains the same; in this case 2 percent - 2 euros - on the amount originally lent. The price drop makes the value of the existing bond comparable to the value of the new bond.”
With government bonds, the creditworthiness of countries also plays a role. “Independent credit rating agencies determine this. The Netherlands, for example, but also the United States, currently has the highest rating: AAA. So, it is super safe to lend money to the Dutch government, because you will almost certainly get your money back. For countries with a lower credit rating, the likelihood that the bondholder will retrieve the lent money is considered to be slightly lower. As compensation, those countries therefore have to pay a higher interest rate on their government bonds.”