Definition of government bonds and debentures
They are the main medium-term fixed income instrument issued by the State. There are 3 and 5 years. Throughout their life, these assets offer a fixed interest rate that is paid through annual coupons.
The Treasury issues on a regular basis and in a standard and stable range of instruments whose life ranges from three months to 30 years, in the following modalities: Treasury Bills (short-term), Government Bonds (medium-term) and State obligations (long-term).
The State Debt will receive the denomination of State Bonds or State Obligations depending on whether its term of life is between two and five years or is greater than this term, respectively. They have the following characteristics:
a. They are titles with periodic interest, in the form of a “coupon”, unlike Treasury Bills, which charge interest in advance.
b. Its nominal value is 1,000 euros.
c. The amortization period will be 3 and 5 years for State Bonds and 10, 15 and 30 years for State Obligations.
d. Interest is charged annually, is a fixed amount and its amount and date of collection is known even before it is issued.
and. It can be acquired, both in the primary market (issuance) and in the secondary market, for its nominal value, below its nominal value or above it. It will depend on the supply and demand in the market and the profitability that is required of the investment.
F. The amortization value will be at par, this is for its face value of 1,000 euros.
Graphic scheme for a 3-year bond purchased on 04-30-20X1 at a price of 105%, with a coupon of 4.10% payable on April 30:
1. How to buy
The acquisition of the titles can be done in two ways:
– In Primary Market.
– In Secondary Market.
a. Primary Market
It takes place when the securities are put into circulation, that is, they are issued for the first time. This form of acquisition is called a “subscription”.
To this end, the Treasury holds periodic auctions to which any natural or legal person may attend, formulating the corresponding subscription request indicating the number of titles and the price they are willing to pay.
In this way, depending on the offers that have been received and according to the financial needs of the Treasury, the price and the amount of debt that is put into circulation is definitively set. Therefore, the issue price will not be known until the deadline for submitting bids has closed and the bid has been resolved. This procedure is common both for Bills and for Bonds and Obligations.
b. Secondary market
All Treasury securities, once issued, are traded on a very active secondary market where assets already issued are traded.
The Public Debt secondary market is divided into two large segments: one for transactions between market members – financial entities authorized to operate in that market – (wholesale segment) and another for transactions between management entities and their clients (retail segment). The first of them is the most relevant, since the prices and interest rates determined in it serve as a reference for the second.
The purchase or sale in this market by private investors can be carried out either through a financial intermediary (banks, savings banks, credit cooperatives, securities companies or agencies…), or through the Stock Exchange.
The price of public debt on secondary markets depends mainly on the evolution of interest rates. Like all fixed-income securities, the price of government securities evolves inversely to interest rates.
2. Market prices
The market price of any fixed-income security is always the result of updating the future flows (known in amount and maturity) at the interest rate in force at that time for the asset in question (yield or IRR).
Bonds and debentures are listed based on the term to maturity and the interest rates prevailing in the market at any given time. In this way, when interest rates fall, the price of bonds and debentures rises. And conversely, if interest rates rise, the bonds and debentures will trade at a lower price, so that the yield obtained by the seller will be lower than initially expected.
Most of the bonds and obligations, and also the Treasury securities – State bonds and obligations – the market price is ex-coupon, that is, the prices that are offered and demanded in the market do not include the running coupon of so that the final price at which we will buy the security will be the result of adding the amount of the running coupon to the listed price.
The concept of running coupon must be taken into account, which is the amount of the coupon or nominal interest that the bond or obligation has accrued (generated) up to a certain date from the effective payment of the last coupon.
3. Calculation of returns
All Treasury securities are ‘fixed income’, meaning they generate a known annual return from the time of purchase, provided it is held to maturity.
However, when the investor decides to sell his securities in the secondary market before maturity, he may suffer losses on the investment he made initially, which does not happen if the securities are held until maturity. This loss may occur if market interest rates have increased since you made the investment; In this case, the right granted by a bill, bond or obligation to receive certain amounts in the future comes at a lower market price. With this, the amount received by the investor may be less than what he initially invested.
Therefore, the full security granted by Treasury securities of not suffering investment losses occurs only when the titles are held until maturity; if they are sold before this date, the risk is assumed that the sale will be made at a price lower than the acquisition price of the securities, depending on market circumstances (price risk or market risk). Variations in interest rates can also work in favor of the investor (when they evolve in a downward direction), which would bring him a higher than expected profit when making the investment.
On the other hand, financial entities generally have commissions for the purchase or sale of securities established in their rates. Its amount will be deducted from the sale price or added to the purchase price, as appropriate, which will make the operation more expensive and reduce the profitability obtained.