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In my country, the interest rates on government bonds are currently 2 - 3%, but I have money in a term deposit at the bank which earns 4% interest. I don't understand how this can be possible. Why are there any buyers of government bonds, either individuals or banks? Why couldn't a bank just deposit its money in another bank instead?

As you can tell from my question, I know very little about economics. I would be really grateful if you could answer in the simplest possible language!

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Anybody or a bank? You seem to be asking about bank would buy gov bonds, but your question is different. Could you clarify? –  MrChrister Dec 21 '12 at 8:28
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It applies to anybody; I just thought that banks were the most likely people to buy bonds. I was actually equally curious about why individuals would buy them, for the same reason. –  Flounderer Dec 21 '12 at 9:02
    
@Flounderer See my updated answer. –  Michael Kjörling Dec 21 '12 at 9:26
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4 Answers 4

up vote 17 down vote accepted

Great question. There are several reasons; I'm going to list the few that I can think of off the top of my head right now.

First, even if institutional bank holdings in such a term account are covered by deposit insurance (this, as well as the amount covered, varies geographically), the amount covered is generally trivial when seen in the context of bank holdings. An individual might have on the order of $1,000 - $10,000 in such an account; for a bank, that's basically chump change, and you are looking more at numbers in the millions of dollars range. Sometimes a lot more than that. For a large bank, even hundreds of millions of dollars might be a relatively small portion of their holdings. The 2011 Goldman Sachs annual report (I just pulled a big bank out of thin air, here; no affiliation with them that I know of) states that as of December 2011, their excess liquidity was 171,581 million US dollars (over 170 billion dollars), with a bottom line total assets of $923,225 million (a shade under a trillion dollars) book value. Good luck finding a bank that will pay you 4% interest on even a fraction of such an amount. GS' income before tax in 2011 was a shade under 6.2 billion dollars; 4% on 170 billion dollars is 6.8 billion dollars. That is, the interest payments at such a rate on their excess liquidity alone would have cost more than they themselves made in the entire year, which is completely unsustainable.

Government bonds are as guaranteed as deposit-insurance-covered bank accounts (it'll be the government that steps in and pays the guaranteed amount, quite possibly issuing bonds to cover the cost), but (assuming the country does not default on its debt, which happens from time to time) you will get back the entire amount plus interest. For a deposit-insured bank account of any kind, you are only guaranteed (to the extent that one can guarantee anything) the maximum amount in the country's bank deposit insurance; I believe in most countries, this is at best on the order of $100,000. If the bank where the money is kept goes bankrupt, for holdings on the order of what banks deal with, you would be extremely lucky to recover even a few percent of the principal. Government bonds are also generally accepted as collateral for the bank's own loans, which can make a difference when you need to raise more money in short order because a large customer decided to withdraw a big pile of cash from their account, maybe to buy stocks or bonds themselves.

Government bonds are generally liquid. That is, they aren't just issued by the government, held to maturity while paying interest, and then returned (electronically, these days) in return for their face value in cash. Government bonds are bought and sold on the "secondary market" as well, where they are traded in very much the same way as public company stocks.

If banks started simply depositing money with each other, all else aside, then what would happen? Keep in mind that the interest rate is basically the price of money. Supply-and-demand would dictate that if you get a huge inflow of capital, you can lower the interest rate paid on that capital. Banks don't pay high interest (and certainly wouldn't do so to each other) because of their intristic good will; they pay high interest because they cannot secure capital funding at lower rates. This is a large reason why the large banks will generally pay much lower interest rates than smaller niche banks; the larger banks are seen as more reliable in the bond market, so are able to get funding more cheaply by issuing bonds.

Individuals will often buy bonds for the perceived safety. Depending on how much money you are dealing with (sold a large house recently?) it is quite possible even for individuals to hit the ceiling on deposit insurance, and for any of a number of reasons they might not feel comfortable putting the money in the stock market. Buying government bonds then becomes a relatively attractive option -- you get a slightly lower return than you might be able to get in a high-interest savings account, but you are virtually guaranteed return of the entire principal. That last is not the case if the bank paying the high interest gets into financial trouble or even bankruptcy. Some people have personal or systemic objections toward banks, limiting their willingness to deposit large amounts of money with them. And of course in some cases, such as for example retirement savings, it might not even be possible to simply stash the money in a savings account, in which case bonds of some kind is your only option if you want a purely interest-bearing investment.

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excellent response! –  littleadv Dec 20 '12 at 21:15
    
Great answer! I think that with term deposits, you usually get a higher interest rate with a larger amount of money, but I did not appreciate that the interest rate would go down again if huge (theoretical) amounts of money were involved. –  Flounderer Dec 20 '12 at 21:38
    
It makes perfect sense though if you stop thinking about interest in terms of money paid because I deposit my money with a bank and instead simply think of it as the price of money. That thinking also works for loans as well. (Remember a bank deposit is as much of a loan as a mortgage is, only reversed; the bank owes you money, whereas with a mortgage, you owe the bank money. Assets and liabilities must balance out in the end, or someone gets a visit from the financial authorities in the relevant country.) –  Michael Kjörling Dec 20 '12 at 21:45
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Building on the excellent explanation by "Miichael Kjörling":

Why would you rather "term deposit" your money in a bank and only earn interest of certain percentage but not not invest in stocks / real state and other opportunities where you will not only earn much higher dividends / profit but will have an opportunity for capital gains, multiple times like Apple's last 4 years(AAPL) ??

This is all down to risk / reward and risk taking.

More risk = More profit opportunities / More Losses ( More Headache) Less risk(Govt BONDS) = Less profit / Less Losses (peace of mind)

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Why would a bank buy government bonds? Why couldn't they just deposit their money in another bank instead?

Generally, banks are limited by laws and regulations about how much they must set aside as reserves. Of the money they receive as deposits, they may loan a certain amount, but must keep some as a reserve (this is called "fractional reserve banking"). Different countries have a different amount that they must set aside in reserves.

In countries where bank deposits are guaranteed, there is almost always some upper limit to how much is guaranteed. The amount of money that a bank would deposit in another bank would be far greater than the guarantee.

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How is it answering the question? –  littleadv Dec 21 '12 at 0:45
    
@littleadv I'll admit the second half touches on one of the points I made in my answer. However, that's only a small part of it. And I doubt the reserve or own-capital requirements much anywhere say anything about how that capital should be kept. There are other issues at play there. –  Michael Kjörling Dec 21 '12 at 8:58
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There are a few other factors possible here:

  1. Taxes - Something you don't mention is what are the tax rates on each of those choices. If the 4% gain is taxed at 33% while the 3% government bond is taxed at 0% then it may well make more sense to have the government bond that makes more money after taxes.

  2. Potential changes in rates - Could that 4% rate change at any time? Yield curves are an idea here to consider where at times they can become inverted where short-term bonds yield more than long-term bonds due to expectations about rates. Some banks may advertise a special rate for a limited time to try to get more deposits and then change the rate later. Beware the fine print.

  3. Could the bond have some kind of extra feature on it? For example, in the US there are bonds known as TIPS that while the interest rate may be low, there is a principal adjustment that comes as part of the inflation adjustment that is part how the security is structured.

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