An Easy Explanation of How Government Bonds Work

in Japan, there is a product called “government bonds for individuals”.
It is a mechanism where individuals can also purchase bonds issued by the government

. However,
the people and institutions buying government bonds each have different purposes.

People who want to earn interest income. Institutions that hold them as part of asset management.
Central banks that purchase government bonds as part of monetary policy.

Even for the same government bond, the reasons for buying are varied

.

Also, the fact that the Bank of Japan holds government bonds and the fact that the government can freely borrow money directly from the Bank of Japan are not the same thing.

In Japan, under the Public Finance Act, the underwriting of government bonds by the Bank of Japan is prohibited in principle, and there are conditions stipulated by law for exceptions. Government bonds are also a mechanism that connects the government with various investors and financial institutions

.
That is what it means. ⸻

What happens when you buy government bonds?

Now, let’s consider a concrete example.

For instance, suppose there is a government bond with a face value of 1 million yen.

The conditions are as follows:

* Face value: 1 million yen
* Coupon rate: 1% per year
* Time to maturity: 10 years
* Purchase price: 1 million yen

* This is a simplified example to help understand the mechanism.

If you purchase this government bond, the annual interest will be

1 million yen × 1% = 10,000 yen

.

And, if you hold it until maturity and the government makes payments as contracted,
you will get back the face value of 1 million yen at maturity.
In other words,

government bonds have a mechanism where you receive interest according to set conditions and receive repayment of the principal at maturity
. That is what it means. However,

there is something to be careful about here. Government bonds are not a product that always yields a profit in every case.

The actual profit or loss will change depending on the purchase price, sale price, taxes,
and the credit status of the issuing country. Also,

the way of thinking differs between holding until maturity and selling midway.

I will explain this difference in detail later. —

Government bonds have a time limit

There are government bonds with various terms.

For example, in Japan,

2-year government bonds, 5-year government bonds, 10-year government bonds, 20-year government bonds, 30-year government bonds, 40-year government bonds

and so on are issued.

* The types and conditions of government bonds issued vary depending on the time.

These numbers like “2 years,” “10 years,” and “30 years”

basically represent the period from the issuance of the government bond to its maturity.

Maturity is the deadline for repaying the principal of the government bond

. For example,
for a 10-year government bond, the period until maturity determined at the time of issuance is 10 years

.
What you want to know here is the point that interest rates and yields can differ depending on the term of the government bond

.
Lending and borrowing money for a short period and lending and borrowing money for a long period involve different outlooks on future interest rates and prices.
Therefore,

short-term government bonds and long-term government bonds may have different yields

.
The “long-term interest rate” often heard in the news is frequently used in Japan as a representative indicator of the yield on 10-year government bonds

. —

Are the “coupon rate” and “yield” of government bonds different?

From here on, it is a somewhat important topic.

When you look up government bonds,

“coupon rate” and “yield”

are two terms that appear.

They are similar, but their meanings are not the same.

🌱 What is the coupon rate?

The coupon rate is the percentage that indicates how much interest will be paid relative to the face value of the government bond

. For example,

if the face value is 1 million yen and the coupon rate is 1% per year, the annual interest is 10,000 yen.
That is what it means.

In the case of fixed-rate government bonds, the coupon rate determined at the time of issuance basically does not change until maturity.

🌱 What is the yield?

On the other hand, yield is a value that represents the rate of return on an investment,
taking into account the purchase price,
the interest received, and the period until maturity. For example,

consider buying a government bond with a face value of 1 million yen for 1 million yen versus buying it for 950,000 yen.
Even with the same government bond, if the purchase price is different,

the return on the invested amount will change.
Therefore,

the yield also changes. What you want to remember here is,

The interest rate is the ratio of interest paid relative to the face value.
The yield is the ratio of return that also takes into account the purchase price.

is the difference.

When you hear in the news that “government bond interest rates have risen,”
it sometimes refers to the yield of government bonds
traded generally in the market. —

Do government bond prices and yields move in opposite directions?

This is a point you especially want to know
in this article.

When the price of a government bond falls, the yield rises.

When the price of a government bond rises, the yield falls.

Why does this happen?

For example, let’s consider a fixed-rate government bond with a face value of 1 million yen
and a coupon rate of 1% per year.

The annual interest received from this government bond is 10,000 yen. Now,

what if market interest rates rise and the interest rate on newly issued government bonds becomes 3% per year?

With new government bonds,

the conditions are set so that you can receive 30,000 yen in interest per year on a face value of 1 million yen.
On the other hand,
the interest on previously issued government bonds remains at 10,000 yen per year

. In that case,
at the same price, the new government bond with higher interest looks more attractive,

right? So,
what should someone who wants to sell a previously issued government bond
midway do?

There may be a need to lower the price so that a buyer appears.
For example,
the previous government bond starts to be traded at a price lower than 1 million yen.

Then,
the buyer can purchase that government bond for a smaller amount.

To that extent, the yield, which is the rate of return on the purchase price, rises.
This is

the reason why government bond prices and yields move in opposite directions.
However,

the actual government bond price is determined by the remaining period, the timing of interest payments, and future interest rate expectations.
It is not simply determined by saying, “Because interest rates went from 1% to 3%,

government bond prices will fall by X%.”

First,

understand the relationship that when interest rates rise,

the market price of already issued fixed-rate government bonds tends to fall.
Let’s keep this in mind
. —

If the price of a government bond falls, do I lose money?

At this point, you might have
a question like this:

“If the price of a government bond falls,
does the person holding it lose money?”

The answer depends on whether you sell it midway
or hold it until maturity. For example,

suppose you bought a government bond with a face value of 1 million yen for 1 million yen.
After that,

suppose interest rates rise and the market price becomes 950,000 yen.
At this time, if you sell it for 950,000 yen,

a loss of 50,000 yen occurs as the difference from the purchase price.
*This is a simple example that does not consider received interest, taxes, or trading fees.
On the other hand, if you hold it until maturity and the government makes payments as contracted,

the face value of 1 million yen will be repaid.

In other words, even if the market price drops midway,
that alone does not mean the face value
you receive at maturity will decrease.

However, there is credit risk that the issuing country
may become unable to fulfill payments.
Also,

if prices rise, the purchasing power of the 1 million yen that is returned might be lower
than it was at the time of purchase.

Therefore, “if you hold it until maturity, you won’t lose money in any sense”

is not necessarily true.

What is important here is that

the risk of market prices falling and the risk of the purchasing power of money falling are different things.

—

What happens to a country’s debt when interest rates rise?

Now, let’s think about this
from the country’s perspective. In the previous article,

I mentioned that when interest rates rise, the burden on the borrower
tends to increase.
This is the same for a country. For example,

suppose the country borrows 10 billion yen anew.
If borrowing at an annual interest rate of 1%, the annual interest is 100 million yen by simple calculation.

Then,
what if it is 3% per year?

The annual interest becomes 300 million yen.

Even if borrowing the same 10 billion yen, the interest burden changes depending on the interest rate. Of course, actual government bonds have various terms and conditions, and the country’s interest payment costs are calculated more complexly. However,

the basic idea is the same.

If you issue new government bonds when interest rates are high, the burden of fundraising tends to increase.
That is the point.

However, the interest on already issued fixed-rate government bonds does not automatically increase due to a rise in market interest rates.

The impact becomes greater when issuing new government bonds or when refinancing government bonds that have reached maturity.
This is

a very important point

when considering America’s debt next time. —

How does the country pay back its debt?

So, how does the government repay government bonds when they reach maturity
?

The government uses revenue sources such as tax income to pay the principal and interest on government bonds.
Also,

to repay government bonds that are reaching maturity, they sometimes issue new government bonds to raise funds.

This is called “refinancing”. For example,

suppose a previously issued government bond reaches maturity.

The government may issue new government bonds to raise the funds for repayment
. In other words, they sometimes use newly borrowed money to repay old debts

. At this point,
“Is that okay?”

you might think.

Refinancing government bonds itself is a mechanism used in government fundraising
.

Just because they are refinancing does not mean the public finances will immediately collapse.

However, if interest rates rise, there is a possibility that the interest payment burden for newly issued government bonds will increase

. Also,
the country’s fiscal situation, economic growth, tax revenue, and trust from investors are also important. That is why, when thinking about national debt, it is important to consider not only “how much debt there is,” but also

“at what interest rate is it being borrowed,” “when does it need to be repaid,” and “how are the funds being raised”
. —

Are government bonds related to our daily lives?

Reading this far,

“I understand how government bonds work, but how do they relate to our lives?”
you might think. Actually,

government bond yields are an important indicator for considering the interest rates of various financial products. For example,

long-term mortgage interest rates. The interest rates when companies borrow money for a long period. The prices of financial products like bonds. These things can be

influenced by government bond yields

. Also,

if the government’s interest payment burden increases, it becomes an important issue for considering fiscal management

. However, just because government bond interest rates have risen, it does not mean that taxes will immediately rise or that living expenses will increase at the same rate.

The actual impact depends on various factors, such as the economic situation and policies. Even so, if you know how government bonds work, when you see news that “long-term interest rates have risen,”

you will be able to think a little bit about it, such as “I see, it also relates to the burden of national debt,” or “it might also affect things like mortgage loans.”

—

How would you explain government bonds to a child?

We have covered some slightly difficult topics so far.

Now, if your child asks you about government bonds,
how should you explain it?

For example, how about explaining it like this?

“The government also needs money to build roads and do various other things.”
“But sometimes, taxes alone aren’t enough.”
“In those times, the government sometimes uses a system where it says, ‘Please lend us some money.'”

“One of the things they issue at that time is a government bond.”

Then, try saying,

“People who buy government bonds are essentially lending money to the government.”
.

You don’t need to explain the entire complex system from the start.
First,

the government sometimes borrows money. When they borrow money, they have a promise to pay it back. Government bonds are one part of that system.

I think just knowing that is enough. When your child gets a little older,
“Why does the government borrow money?”

“What is the borrowed money used for?”

thinking about these questions together

is also a good idea.

⸻

Summary | Understanding government bonds helps you connect the dots on interest rate news

This time, I talked about the basic mechanism of government bonds
.

Finally, let’s review the important points.

1. Government bonds are securities issued by the government to borrow money.
2. People who buy government bonds become the side that lends money to the government.

3. Government bonds have conditions such as interest and maturity.
4. Bond prices and yields generally move in opposite directions.

5. When interest rates rise, the burden of issuing new government bonds tends to increase.

6. Government debt is also related to our daily lives and the economy.

So far, we have learned about deposits and interest rates
. At first, we started with a familiar question:

“What happens to the money I deposit in the bank?”. From there, we gradually broadened our perspective with questions like

“What is interest?” “What are interest rates?” “Does the government also borrow money?”

. Thinking about it this way, you can see that

the financial system is not made of separate stories, but is all connected

.

I myself didn’t understand it all from the beginning.
Every time a difficult word came up, I learned little by little while researching,
“What does this mean?”

. That is precisely why I want to convey this to those who feel,
“I want to know about money, but it’s difficult and I don’t really understand it,”

using

the most accessible language possible

.

As your knowledge increases, your perspective on the news changes.
As your perspective on the news changes, you have more opportunities to think about your own money.

And,
that accumulation leads to future choices. It doesn’t have to be perfect. A little at a time is fine. I hope to reduce the anxiety of not knowing and help you reach a point where you can make choices based on knowledge. I would be happy if we could continue to increase that kind of learning together. 😌📚♡ How much did you know about

government bonds
? ”

I only knew it was government debt!” “This is the first time I learned that prices and yields move in opposite directions!” Please let me know your thoughts in the comments
♡ ⸻

📚 Next Time | Quiz! The Relationship Between US Debt and Interest Rates

So far, we have learned about how government bonds and interest rates work.
Now, here is a question for you.

If U.S. long-term interest rates continue to rise, what kind of problems
could potentially occur?

Just like Japan, the U.S. borrows money by issuing government bonds.
And,

U.S. government bonds also play an important role
in global financial markets.
So,

what happens when interest rates rise while the U.S. has such a large debt?
Next time,

with the theme of “Quiz: The Relationship Between U.S. Debt and Interest Rates,” we will use the knowledge we have learned so far

to think about it.

Government bond prices. Long-term interest rates.

The country’s interest payment burden.

I think this will be the episode where topics that seemed separate until now all connect.

Please be sure to try the quiz out!📚♡