Running a company and running a government are not so different; Both have responsibilities to stakeholders, and both require money to operate.
While governments are responsible for the improvement of their citizens’ quality of life using limited budgets and resources, companies are responsible for ensuring consistent returns for their shareholders using a finite number of employees and limited funds.
Governments spend money on different areas, all of which help provide necessary services to citizens. These areas include: Transportation, infrastructure, security, national defense, social programs, education, and healthcare.
As you can probably imagine, these activities are costly. Raising money to ensure they are consistently managed is no easy feat.
Governments raise money through a several activities. Some of the most important ones include:
In this post we’ll ignore most of the cool mechanisms above and, instead, focus on the most boring one: Borrowing Money. We choose to focus on this not because we are boring people, but because this money raising mechanism is the most relevant in the context of individual investments.
Now, imagine how hip you’ll sound the next time you try explaining this at a loud, crowded lounge.
A government bond is nothing more than a fancy name for an agreement between a government and a lender. This agreement outlines the conditions the lender and the borrower agree to. Typically, the agreement looks something like this:
I as a lender agree to lend the borrower (the government) $100 today, in return for $105 next year.
Although over-simplified, this is exactly what government bonds represent. When you dig deeper into how bonds work, you immediately start to see small contractual differences worth mentioning:
Governments issue bonds for specific durations. These durations are what we call a bond’s “maturity”.
For example, a 3-month bond matures after three months; The lender can expect his money back plus interest three months after issuing the loan or purchasing the bond.
On the other hand, a 20-year bond with an interest rate of 3% means the lender will get his money back after 20 years, but will earn 3% every year until maturity.
As we have discussed in our post on interest, the more risk you take as a lender the more you should get compensated for it.
That said, not all government are created equal. The current and future stability and reliability of a government directly impacts how expensive it is for it to borrow money.
For example, investors consider the governments of developed countries more stable than those of developing countries.
So naturally, the interest rates you can expect from U.S. or Canadian bonds are lower than the rates you can expect from, say, Middle Eastern governments. In theory, you risk less lending money to the U.S./Canada than you do lending money to Middle Eastern countries. In theory (pause with intentional lack of clarity).
The exact same processes described above can apply to companies as well! In fact, raising capital by issuing corporate bonds is a major source of income for companies.
The primary difference between corporate bonds and government bonds is that corporate bonds are a lot riskier, therefore offer more lucrative interest rates.
It is a fact that corporations fail more frequently than governments do, so it is only natural that they reward you more for taking on this additional risk as an investor.