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The government securities

The role, benefits, pitfalls of government securities and what else you should know about it

A government security is a special bond that can be part of your investment basket. If the state needs money, it can borrow from banks, print money, or just turn to investors. In the latter case, it issues government securities. This can be done by the states of any country.

You can access government securities directly from the issuer (for example, you can reach the Hungarian issuer here), and if you have a securities account, you can also buy through this. Of course, you can get it not only on your own, but also as a “package” on mutual funds.

Treasury bond, treasury note

 

What is the role of government securities?

In the bond market, the state occupies a central position as an issuer. The reason for this is that the state is considered a credit risk-free issuer in the domestic currency.

Although here, too, the security embodies debt, as in the case of any other bond, but the state has the opportunity to raise the required amount at any time through taxation and, if necessary, cash printing. No other issuer has the option to do this. For this reason, government securities also act as a benchmark, ie the risks and returns of all other bonds are compared to this.

What is government security? Let’s take it in more detail!
A government security is a debt security issued by the state.

By purchasing a government security, you lend to the state.

The role is the same everywhere, but the name changes according to the term. If the maturity is:

  • less than 1 year, it is called Treasury Bill (T-Bill)
  • more than 1 year but less than 5 year: it is called Treasury Note (T-Note)
  • more than 5 years: it is called Treasury Bond (T-Bond)

(Terminology can vary from country to country. In Hungary, for example, it is grouped only by maturities of less than 1 year or more than 1 year.)

What makes government securities different from a bank deposit?

With a bank deposit, you are actually lending to the bank to use your money for interest. With government securities, you lend the same money to the state. The two differ in that you will not be able to access the bank deposit without losing interest until the end of the term.

The government security pays you interest at the time specified at the time of issue, which remains yours even if you sell the security later but before the expiration date.

That’s how we got to the second difference. You can sell a government security at any time at the current market rate against a bank deposit.

Why doesn’t the state print money instead of paying interest on government securities?

In order for the state to solve its numerical (i.e. nominal) capital needs, it would also have the option to print money. As the total value of government securities in circulation can be measured in billions, if they were to print money, it would trigger very significant inflation.

According to one of the basic tenets of economics, the more a given instrument is available at a given moment, the more its value decreases.

The state, of course, wants to avoid this, so it turns to investors and finances the necessary amount with the money they have. Therefore, in return, it is much more profitable for the state to pay interest than to solve the deficit from its own resources.

The government balance is used to finance the current account and to refinance government debt (ie to repay previously incurred debt from a “loan” taken out through government bonds). From this you can see that the state, unlike companies, does not necessarily finance productive activities, it may not produce new value, so it cannot extract interest.

That’s why they can choose between at least inflating the interest rates or going bankrupt. Usually the former is chosen. Then the currency’s purchase power deteriorates so much that it can pay the interest numerically, but the purchase value does not change much.

Look at the next two pictures and the similarity will be striking. This is a representation of Hungarian inflation and government bond yields, but this is not a snatched example, you will find a similar situation in other countries.

Inflation 1997-2019
Development of Hungarian inflation 1997-2019, Source: CSO

 

Yield on government securities
Yield on government securities, Source: akk.hu

You could say that 20-year-old government securities still exist and are available to anyone at high interest rates. It is true, but you can only buy these from someone and you can expect that the market has already priced in the lower interest rates now. So you’re not going to win a lot with it anymore unless you’re the one who bought that paper that year.

Do you benefit from high-interest government securities?

What do you think when a government security of a country (even a Hungarian one) offers an exceptionally high interest rate, why don’t foreign investors stand in long crowded queues to bring their money here?

Simply because they know exactly that if they buy a Hungarian government security, they will get it back in Hungarian forint, because usually the state won’t pay the higher interest rate to the euro-based government security. They will later have to convert this forint into the currency that is important to them (eg where they came from). Because they know that government bond interest rates and inflation will hit similar levels, they also know that although they will receive a numerically higher amount for their money, they will buy less foreign currency from it.

The same can be observed with you, only you usually do not buy less foreign currency, but anything else. Whether a product or service, some or even all of which is imported from abroad, say for euros.

Properties of a government bond

Interest on government securities

It can be in terms of interest on government securities

  • fixed interest rate,
  • variable (floating) interest rate.

If the interest is fixed, the interest determined at the time of issue remains unchanged over the entire term and is paid to the respective owner at specified intervals at the time of issue.

In the case of variable interest rates, the interest rate can also be expressed, for example, in relation to inflation. This looks like this: current inflation + X%.

The interest rate may change over time. For some schemes, the state offers higher and higher interest rates over time.

What does it mean if you bought a government bond for HUF 1 million with an interest rate of 5%?

You will then receive interest at the rate of 5% per annum (from which the payer will deduct interest tax in accordance with applicable law), and at the maturity you will also receive interest and face value in the same way. The interest payment may not be annual but, say, semi-annual, in which case you will receive the interest earned in two installments.

Yield on government securities

If you buy a government bond at issue and hold it until the end of the term, the interest and yield are the same.

A bond, such as a government bond, is transferable in the same way as any other security, say a share. The exchange rate varies according to supply and demand, so it may even be different on a daily basis.

If investors expect a higher return elsewhere with a similar level of risk, they will sell their government securities, the price will fall due to the increased supply.

That’s why it can happen that what’s worth 1 million at face value isn’t bought for 1 million, but for, say, 900,000. Then the state pays 5% interest on 1 million in the same way, so at the price of 900,000 it is as if your interest is not 5% but higher. This has increased your return.

Of course, there are also examples of government securities with a nominal value of HUF 1 million being paid more than that. This typically occurs in an economically uncertain situation where investors are uncertain and looking for guaranteed opportunities. Even then, the interest is after HUF 1 million, but since the buyer paid more for it, his yield decreases.

Government security guarantees

If you buy a government security through the state treasury, both capital and a yield guarantee “go” to the government security. This yield guarantee only guarantees the payment of interest. If you sell your investment sooner, even below price, of course, don’t expect that.

If you did not buy directly from the state treasury, but invested through a distributor, IPF stands behind the investment. IPF is right in all cases where the financial institution that manages your investment is insolvent, but if you make a bad decision and you make a loss because of it, the responsibility is yours.

Think domestic (here it is Hungarian) or foreign government securities?

In Hungary, you have the easiest access to Hungarian government securities. You can achieve this on a forint or euro basis.

Regardless, you can follow the example of large investors who use government securities as a tool for capital building. In this case, in addition to equity investments, a low-risk security is chosen whose price moves either completely independently of the shares or vice versa. That is, its correlation is either 0 or negative.

A good example of this is either a Chinese government bond (which has a positive yield) or, say, a bond of a relatively stable and large German state with a negative yield.

Negative yields, while sounding strange, are an existing phenomenon. Then you pay for the German state to use your money. The fact that there is still demand for it is basically due in part to the fact that a significant amount of money is looking for its place. As there is demand, further interest rate cuts are expected. In the event of an interest rate cut, a bond previously purchased at a relatively higher interest rate will appreciate. Thus, if investors expect interest rates to fall further, a German government bond could be a good buy even with a negative interest rate. (Not to mention that there aren’t too many alternatives that differ significantly from this if we look very closely at the correlation with stock prices and the level of risk.)

You can do the same in a small amount, it is good to have a healthy amount of government securities in your investment portfolio. You can do this directly or through an investment fund.

What are the risks of government securities?

Government securities are one of the safest investment vehicles. There is very little (but not zero) probability that a state will go bankrupt, making it impossible for them to repay the bonds. Still, there are some risk factors that you should definitely keep in mind before you put money out of your hand.

Rating of the state as a borrower

This is true for any government bond, but now let’s stay with the Hungarians, as this is the most used one in Hungary.
As Hungary takes out a loan by issuing government securities, it is important to know the risks inherent in the “person” and management of the borrower. Since you are buying the government security, one of the creditor is exactly you, so you need to know the “debtor” well. Just like you lend to anyone else.

This is what certification companies help with. The three best known are Moody’s, Standard & Poor’s, and Fitch.

Currently, Moody’s Baa3, Fitch and S&P classify Hungary in the BBB category. This is exactly the category proposed for investment, so if the situation worsens, Hungarian government securities are easily classified as speculative bonds. However, this can have very serious consequences (it is true for every state).

distribution of government securities
distribution of government securities, Source: MNB

On the left side of the report issued by the National Bank, you can see the Hungarian government securities stock in thousands of forints, and on the right side in%. Yellow for credit institutions, blue for households, black for foreign investors and red for other owners.

The effect of the downgrading of Hungary

A significant part of the Hungarian government securities portfolio is in the hands of foreign investment funds and pension funds. If Hungary’s rating (or any other state’s) becomes speculative, these investors will almost necessarily sell their securities. They do so typically because their investment policy prohibits them from investing in speculative-rated assets. You can find them here in Hungary, so not only foreigners would get rid of government securities. A direct consequence of this would be a significant fall in government bond prices.

If foreigners were to sell large amounts of their government securities held in forints, this would also have a negative effect on the forint exchange rate (this is also true for all other states and currencies).

In that case, it would not make sense to keep the capital in forints any longer, so they would switch to either euros or dollars or some other currency. Then this means that they would sell a large amount of domestic currency and buy foreign currency from them. The greater the sudden onset of supply, the greater the weakening of the exchange rate.

You could say it doesn’t affect you, take their money. However, you can very easily experience the weakening of the domestic currency on your own skin. Then the prices of all products and services that are not 100% domestically produced will increase, and over time they will spread to other sectors of the economy as well.
As Hungary currently imports a lot of things, this deterioration in rating would be reflected in a general price increase. Most of the price increases would be due to imported inflation.

Interest rate sensitivity as a function of time horizon

The time interval is also called duration.

The longer the term of a government security, the greater the uncertainty. This uncertainty is accompanied by higher interest rates. This is good news so far, but the price of a longer-term bond is much more sensitive to a change in interest rates (for example, when the central bank raises interest rates) than it is to a shorter-term one.

If you anticipate that interest rates will rise, be sure to choose a bond with a shorter duration. This is because the price of previously low-yield government bonds will fall, while a bond with a shorter duration will be less affected.

With the current record low interest rates, it is not viable to expect a substantial interest rate cut by the Hungarian central bank. In another market situation, as interest rates fall, the price of a government bond previously issued at a higher interest rate will rise. If you consider this scenario plausible, choose a bond with a longer maturity, as this will increase its price significantly. So if you sell, you win more, and if you keep it, you get a higher interest rate for a longer period of time.

Who is good at government securities?

I can say to everyone because you can choose from all kinds of maturities and interest rates 🙂

But it’s not healthy that 100% of that makes up someone’s investment, especially not in the long run. Then even though your money is safe, it’s accessible, and you get all the interest on it, you won’t achieve as much growth with it as you would with a properly put together portfolio.

It has a place in a balanced investment basket, as this gives you the opportunity to keep some of your money in an easily accessible place and thus spray the risk. This can work for you in the same way that higher-yielding mutual funds keep some of their money liquid.

Questions:

  1. How long would you keep your money in government securities?
  2. Do you think for example that Hungarian government securities (as a small country) will have a negative interest rate?
  3. How would you take advantage of the opportunity provided by government securities to build capital?

If you would like to make the most of the opportunity provided by government securities, please contact us to arrange an appointment for this.

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