Investing In Government Bond Funds – What You Need to Know

 

Government bond funds invest primarily in US Treasury Bonds. They may also invest in government agency bonds. Basically, they hold the safest debt instruments on the planet. Relative to other types of bond funds, the probability that a Government Bond Fund will suffer from an issuer defaulting is tiny.  That does not mean that you cannot lose money in these types of funds however. If you invest in a government bond fund, you may lose a significant amount of your initial investment if interest rates go higher.

Right now (June 2012), interest rates on treasury bonds are near all time lows.  The 10 year Treasury Bond is yielding 1.64%. Five years ago, it  yield 5.0%. Twenty years ago, it yielded 7.5%, and 30 years ago the ten year treasury yielded almost 15%. The point is simple, current interest rates are very, very low.  Even if interest rates on the 10 year treasury were to double from their current levels, they would still be very low when measured against the last 30 years.

The fact that interest rates are this low has two important implications for investors in government bond funds.

  1. The overwhelming majority of a fund’s performance will not be a result of receiving interest from the treasury bonds held in the fund.  It will instead come as a result of changes in the market price of those bonds. For example, long-term government bond funds from June 2011 – June 2012 had a total performance gain of 36%. During that time approximately 3% out of the 36% gain was attributable to interest income.
  2. If interest rates continue to fall investors in government bond funds will make money, if they start to rise they will lose money.  A bond’s market price and yield are inversely related. As interest rates go down, the price of Treasury bonds rise (you can learn more about this here). Or put another way, an investor in a government bond fund is effectively betting that interest rates for the bonds in the fund will fall. (There are some bond ETFs that enable an investor to to make the reverse bet, which you can read more about here.)

Essentially, there are four types of government bond funds which enable investors to pick which maturity dates they want the fund to hold.

  1. Ultrashort
  2. Short-term
  3. Medium-term
  4. Long-Term

The longer the average maturity date of the bonds in the fund, the more the value of the fund will fluctuate as interest rates change.

The difference in maturity dates explains why there are still major differences in the performance of different types of funds, and even within the same category of fund. For example, an intermediate fund can hold bonds with maturities from 4 to 10 years. A fund with an average maturity of 4 years will produce very different returns than a fund with an average maturity of 9 years, even though both would be categorized as intermediate term government bond funds.

There are some government bond funds that only include strips. “Strips” are bonds that have been stripped of their coupon payment. If you had two identical bonds, except one is stripped and the other is not, the one which has been stripped will be more reactive to chagnes in interesr rates.

Want to know more about bond mutual funds and ETFs?  Visit the Bond Funds section of Learn Bonds.

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