Did you know that you can lend money to the government?
Lending money to the government is not for everyone. But you can if you want to, by buying a government bond.
Few are aware of this, and it’s not known as a particularly good investment either, but there are many good reasons to lend money to the government.
“For investors, lending money to the state is primarily a good way to ensure that you have access to liquid funds, i.e. quick money,” says Siri Valseth, an associate professor at the University of Stavanger.
A loan that can be bought and sold
Valseth wrote her PhD dissertation on government bonds.
“A bond is a loan,” Valseth the associate professor said.
“But it’s not an ordinary loan. A bond is a negotiable loan or a security if you will, which can be bought and sold in a market.”
The most well-known types of bonds are when governments or companies borrow money.
If it’s the government that is borrowing money, they’re called government bonds. If companies borrow, the loans are often called corporate bonds or credit bonds.
Perhaps it was simpler in the past: physical bonds were sold as pieces of paper. Attached to the paper were small notes with the fixed interest rate.
The coupon rate note could be exchanged for cash in the bank, as the annual payment for lending the money.
Shares vs bonds
As is well known, a company can issue new shares to raise capital to grow their business or invest. In this case, it sells shares in the company. These shares can be bought and sold.
Another way to raise money is to issue bonds. If you buy bonds, you are lending money to the company. As with stocks, you don't have to sit on them. You can sell them if you want.
But why doesn't a company borrow money from the bank instead?
“It can do that, but sometimes the company can raise higher amounts at better interest rates in the bond market than in the bank. The bank makes its own assessments about the risks of lending to a company. The market — where many different investors participate — can make other assessments,” Valseth said.
It’s worth noting that you as an individual actually can’t trade in corporate bonds. Bonds deal with large amounts and are not suitable for trading by private individuals. The minimum amount for bonds is usually between NOK 1,000 and one million, and the loans are usually several hundred million NOK or more.
- A bond is a security that shows that you have borrowed or loaned some money. The person who needs the money is the borrower, the person who buys the bond is the lender.
- The bond is therefore a security. It says how much you have borrowed, what interest payment you will receive, and when the loan must be repaid.
- When the government collects money like this, they are called government bonds. Other authorities such as county councils and municipalities can also raise money through bonds.
- When private companies borrow money in the same way, they are called corporate bonds or credit bonds.
The state borrowed 10 billion
Bonds cannot be traded directly in the same way as shares on the Oslo Stock Exchange. Bonds must be traded via an intermediary, called a market maker. Large banks are also often the facilitators when companies or the state issue bonds.
An issuer posts the loan, the bond, Valseth said.
On 26 September this year, the Norwegian state raised NOK 10 billion. Norges Bank handled the issue on behalf of the ‘Kingdom of Norway’. The loan runs for 20 years. The price it was actually sold for gave an annual coupon rate of 3.6 per cent. Three quarters of the loan came from Norwegian lenders.
“That issue is the first time a 20-year government bond has been issued in Norway. In the past, it has been common to issue 10-year government bonds,” Valseth said.
Norges Bank keeps an overview of various government bonds, maturities and interest rates (in Norwegian).
“Unlike bank loans, many lenders share the risk when the loan is distributed as a bunch of bonds. These can be sold to many different investors, who thus share the risk. Unlike a bank loan, the lender can sell and get rid of the bond if they don't like the risk, need the money or want to invest in something else,” Valseth said.
It is understandable that companies need money. But the Norwegian state is, after all, full of value. Valseth explains that the state needs cash to lend further. Money that is lent from Lånekassen, the government's loan fund for education, the Norwegian State Housing Bank, and Export Finance Norway are raised via government bonds.
Is this a way to make money?
But how do you make money on bonds? Whoever collects the money, i.e. the issuer and seller of the bond, promises an annual interest rate. The coupon rate comes automatically for government bonds.
The terms of a loan like this can vary from a few years to several tens of years. The market value of the bonds changes all the time. If you need the money and want to sell the bond, the value may therefore have increased or decreased. But the coupon rate is fixed.
If the coupon rate of a bond of, for example, NOK 1 million is set at 2 per cent, this means that you will be paid NOK 20,000 a year. If a loan matures after ten years, you have thus received NOK 200,000 along the way, which can be reinvested, and you will eventually get your million back.
But is this payback greater than the inflation rate?
“Government bonds tend to have low interest rates. The Norwegian state will not go bankrupt. A government bond is a safe security, which you can quickly turn into money if you need it,” Valseth explains.
If interest rates fall in the general market, you can make money by selling the government bond. But you can also lose money.
“But you lose money by borrowing from the state if you have to sell the bond before it matures and interest rates have risen,” Valseth said.
“If interest rates rise in the general market, you may only get NOK 900,000 for the bond when you sell it. The buyer will still receive the original coupon rate. This means that the interest rate rises for the buyer, because NOK 20,000 of NOK 900,000 is more than 2 per cent.
So why is there a market like this if there isn't much money to be made?
“The return on government bonds is low. But again – security and liquidity are high. You make sure you have money quickly available. An insurance company, for example, must have safe assets, which remain stable in value and are easy to convert into money. Therefore, they like to place funds in government bonds,” she said.
More money in companies
The coupon rates on corporate bonds are normally much higher. Nevertheless, these are not very much more attractive. That is because the market is smaller and the risk greater.
“The secondary market for corporate bonds is not that liquid,” Valseth said.
“There are many buyers and sellers of government bonds at any time. When it is easy to buy and sell relatively large amounts without affecting prices in any particular way, we say that the market is liquid,” Valseth said. “Thus, the prices are more stable. Since there are fewer buyers and sellers in the corporate bond market, prices become more volatile. If you buy a corporate bond and sell it again, the higher the amount, the greater the chance that the price will be lower.”
With a better coupon rate on corporate bonds, there is naturally more to be gained from lending to private individuals. But there is also an additional risk: If the issuer has payment problems or goes bankrupt, and cannot pay interest or repay the loan, you can lose money, Valseth said.
The effect of increased interest rates
Are bonds worth more now that interest rates are rising?
“No, the effect is the opposite. Now that interest rates are rising, the price of bonds is falling. Old bonds become less attractive, because they usually have a lower coupon rate. But new bonds will have to have a higher interest rate, as they have to reflect the market,” Valseth said.
This rate will be higher than the normal deposit rate in the bank, she said.
“Yes, it will most often be higher for government bonds, because the interest rate on deposits is absolutely miserable,” Valseth said.
But this raises the question as to why people aren’t racing to buy new government bonds if the terms are better than with regular banks. Valseth said it’s complicated.
“Bonds are a bit more cumbersome to buy and if you need the money back before the bond matures, you don't know what price you will get when you sell. A bank allows you to withdraw money from your account whenever you want. If interest rates rise in the next few years, the bond could drop a good deal in value, causing you to lose money if you sell before it matures,” she said.
These characteristics make investing bonds not a good choice for older people, she added.
“Here you have to know what you are doing. But you can trade via bond funds, which are a collection of different bonds. Then you can go to Storebrand, Gjensidige, DNB or wherever else you go to invest in funds,” Valseth said.
Translated by Nancy Bazilchuk
Read the Norwegian version of this article at forskning.no