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The pros and cons of government bonds

This article is part of
Guide to Fixed Income Investing

Government bond risks depend on what governments one is considering.

Sovereign bonds issued by major economies such as the US, UK, Germany and Japan usually offer several advantages, says Neil Mayfield, principal at Mayfield Investment Management.

In particular he cites the liquid, transparent markets and a range of instruments and terms in which to invest, such as index-linked, zero coupon and irredeemable bonds.

Furthermore, directly owning UK government bonds, called ‘gilts’, will incur no capital gains tax for the clients.

If one is considering highly-rated government bonds, then the risk of default and irrevocable loss of some or all of your investment is negligible.

But the consequence of this low risk, explains Kevin Telfer, fixed income product specialist at Kames Capital, is that the long-term return potential from these investments is lower than other fixed income asset classes. Government bond yields in the UK and US are currently at historic lows, for example.

“However, this lower risk also means that high quality government bonds tend to outperform other riskier asset classes in times of economic and market stress, providing investors with a defensive element to their overall portfolio.

“As one starts to move down in credit quality, government bonds take on the risk/reward characteristics of corporate bonds, although often with added political risks.”

Mr Mayfield points out that some sovereign debt offers more risk than many major companies’ corporate debt.

He suggests Greece versus Microsoft as a suitable example, adding that all eurozone governments are unable to print money to meet their obligations and so increasing the risk of default.

“Large economies can offer a false perception of security such as Russia who defaulted on their debt in 1998,” he warns. And if a country gets into difficulties and starts to struggle with servicing its debts, it can tend to favour its domestic investors over its international investors.”