The Financial Risks of Government Bonds

Government bonds are considered to be least-risk investments. They are backed by the full faith and credit of the government. Standard & Poor’s gives U.S. government bonds the highest rating possible. Government bonds carry some financial risks, just like any other investment.

Federal government bonds have a low risk of default because the government can always:

  • Raise taxes to pay debts
  • Borrow money from other countries
  • Print more money

This does not mean that is impossible for the U.S. government to have a hard time paying back bonds. Though unlikely, if there is a devastating wartime or financial crash, the government may not be able to repay at the promised time. And, as always, there is a market risk for any type of investment. Remember that bonds are subject to interest rates. You could buy a 20-year bond at 4% interest and tomorrow (or even 5 years from now) the same bond could rise to a 6% interest rate.

State and local government bonds are considered more risky than Federal bonds. They offer more competitive interest rates because they can go bankrupt. These municipal bonds also allow bondholders to be exempt from taxes.

There are some instances where State governments have had issues:

1. Orange County, CA: In 1994, the Orange County, CA municipality filed for bankruptcy. The county treasurer, Bob Citron, devised a plan to invest deposits from the County Investment Pool. This pool was made up of monies from the county government and about 200 public agencies. He invested in derivatives, inverse floaters, and long term bonds that paid high yields with this money. He borrowed against the borrowed money and lost the county about $1.64 billion dollars. The banks he borrowed from began to seize the assets of the County Investment Pool and the county filed for bankruptcy. All of the bondholders of the O.C. were out of luck.

2. Cleveland, OH: In 1980, the capital declared a fiscal emergency which also applied to all municipalities in Ohio. For years, their general fund expenses exceeded their revenue and they could not issue, refinance, renew, or repay notes. They had to borrow $15 million dollars from the State of Ohio to pay its debts on the condition that their financial progress would be monitored by the State.

Basically, federal bonds are less risky than municipal bonds but both trump that of the general market. Because they either can borrow money or raise taxes (sigh) it is more likely that you will be paid back your money in the instance of default.