What is a Government Bond?

Government bonds have spent a lot more time in the news recently.

You might have heard about rising government debt, gilt yields reaching levels not seen for years or the increasing amount the Government is spending on interest on its debt.

It can all sound like a fairly complicated corner of finance.

Underneath it, though, is something much simpler.

Governments borrow money.

One of the main ways they do that is by issuing bonds. 

A Government Bond Is Basically an IOU 

Imagine the UK Government wants to borrow £100 from you.

In return, it agrees to pay you interest for an agreed period and then repay the £100 at the end.

That, in simple terms, is a government bond.

In the UK, government bonds are known as gilts.

Most UK government bonds work in a fairly straightforward way.

The Government borrows money.

Most gilts are known as conventional gilts. They pay a fixed amount of interest, known as the coupon, which is normally paid every six months.

At an agreed date in the future, known as the maturity date, the amount borrowed is due to be repaid.

Why Does the Government Borrow Money?

Governments receive money through taxes and other sources of revenue.

They also spend money on things such as healthcare, education, pensions, defence, infrastructure and public services.

Sometimes the Government spends more than it receives.

Borrowing helps finance some of that difference and issuing government bonds is one way of doing it.

There is another reason governments regularly issue bonds.

Existing bonds eventually reach the end of their agreed term and need to be repaid. The Government may issue new bonds as part of replacing that old borrowing.

So government borrowing isn't only about covering the gap between what the Government receives and what it spends.

This also helps explain the difference between two things you might hear mentioned in the news.

A deficit broadly describes the gap between government income and spending over a particular period.

Government debt is the amount that has built up over time.

They are related, but they aren't the same thing.

Who Lends Money to the Government?

Government bonds are owned by all sorts of investors.

They include pension funds, insurance companies, investment funds, banks, overseas investors and individuals.

So even if you've never knowingly bought a government bond yourself, you may already own some indirectly.

A pension or investment fund, for example, might hold a mixture of shares, government bonds and other investments.

This is one reason the government bond market isn't quite as distant from our own finances as it might first appear.

What Happens After a Government Bond Has Been Issued?

When a government first issues a bond, investors lend it money in exchange for the promised future payments.

But they don't necessarily have to keep the bond until it reaches the end of its term.

Once issued, government bonds can be bought and sold between investors.

This is where things become a little more interesting.

Take our £100 government bond from earlier.

You might assume that bond must therefore always be worth £100.

It isn't.

The bond may also have several years of interest payments still to come.

So someone buying it isn't simply buying the right to receive £100 in the future. They're buying the right to receive those remaining interest payments as well.

Depending on how attractive those future payments look compared with other investments available at the time, somebody might be prepared to pay £95 for the bond.

Or £105.

Remember, they're not just buying the £100 repayment. They're also buying the remaining interest payments.

The £100 is the bond's face value – the amount the Government has promised to repay when the bond matures. That hasn't changed.

What can change is the bond's market price – the amount somebody is willing to pay today for those future payments.

Understanding that makes the next part much easier.

What Is a Bond Yield?

Let's continue with our bond with a £100 face value. Suppose it pays £3 of interest each year and eventually repays £100 when it matures.

The £3 annual payment is fixed. That's the bond's coupon.

What isn't fixed is the price somebody might be willing to pay for the bond after it has been issued.

If it costs £100, the £3 annual interest payment is equivalent to 3% of the price.

If its price falls to £95, the bond still pays £3. That £3 payment is now equivalent to about 3.16% of the price paid.

If its price rises to £105, it still pays £3. The £3 payment is now equivalent to about 2.86% of the price paid.

Those percentages aren't the bond's full yield. They simply help show why paying less for the same promised payments increases the return available to a new buyer.

A bond's yield is a way of expressing the return available to an investor based on its current price and the payments it is expected to make.

A bond's full yield calculation also takes account of all the payments still to come, including the £100 eventually repaid when the bond matures. That's why the actual calculation is a little more complicated than simply dividing the annual interest payment by the price.

You don't need to understand that calculation to understand the important relationship between a bond's price and its yield.

The coupon hasn't changed. The price has.

As the price falls, the return available to a new buyer increases. As the price rises, the return available falls.

So what might cause the price to change?

Suppose interest rates rise and the Government starts issuing new bonds that offer investors a higher return.

An investor looking at an older bond might reasonably think:

Why would I pay £100 for that when newer bonds are offering me more?

To attract a buyer, the price of the older bond may therefore have to fall.

Its promised payments haven't changed. The lower price simply makes those payments more attractive to a new buyer.

In bond-market language, the yield has risen.

The opposite can happen too.

If an existing bond looks particularly attractive compared with newer bonds, investors may be willing to pay more for it. Its price rises and the yield available to somebody buying at that higher price falls.

This gives us one of the most important things to understand about bonds:

When bond prices fall, yields rise.

When bond prices rise, yields fall.

Why Do Government Bond Yields Rise?

There isn't one reason.

A useful way to think about it is to ask:

What might make investors want a better return before lending their money?

Interest rates are one factor. As we've just seen, if newer bonds offer investors a higher return, older bonds may need to fall in price to remain attractive.

Inflation can matter too.

If prices are rising quickly, fixed payments due many years into the future won't buy as much as they would today. Investors may therefore want a higher return to compensate for that.

The amount the Government needs to borrow can also matter. If lots of new bonds need to be sold, there still need to be enough investors willing to buy them.

Then there is the wider economic outlook.

Investors are constantly deciding what they're prepared to pay and what return they want in exchange for committing their money.

That's why it is too simplistic to say that more government borrowing automatically means higher bond yields.

Interest rates, inflation, the amount of bonds being issued, demand from investors and wider uncertainty can all play a part.

Why Do Higher Government Bond Yields Matter?

If you've never bought a government bond yourself, you might reasonably wonder why any of this matters.

One reason is what it costs the Government to borrow.

If investors now expect a higher return before lending their money, the Government may have to offer more attractive terms when it issues new bonds.

That doesn't mean every bond the Government has already issued suddenly starts paying more interest.

Those existing conventional bonds continue making the payments already agreed.

The effect tends to build over time.

When the Government needs to borrow more money, or replace old borrowing as bonds mature, the return investors require may be higher.

Over time, that can increase the amount the Government spends paying interest on its debt.

Government bond yields also matter beyond the public finances. They influence the wider financial system too.

If investors can earn a certain return by lending to the Government, that can affect the return they expect from lending or investing their money elsewhere.

Government bonds are also held within many pension and investment funds, so changing bond prices can affect the value of investments people already own.

Something that initially sounds quite remote can therefore have consequences much closer to home.

Are Government Bonds Safe?

Government bonds are sometimes described as safe investments.

That needs some context.

A conventional gilt is designed to repay the amount due at maturity, provided the Government meets its obligations. The Debt Management Office says the British Government has never failed to make the interest or repayment of principal due on its gilts.

That doesn't mean you can't lose money by owning one.

Suppose you buy a government bond for £100 and later need to sell it.

If interest rates have risen and investors are now only prepared to pay £90 for it, you may have to sell for less than you paid.

There is also inflation to consider.

A fixed amount of money promised many years into the future may not buy as much by the time you receive it.

The Government also issues index-linked gilts, where the interest payments and the amount repaid at maturity are adjusted in line with the Retail Prices Index. These work differently from the conventional government bonds we've mainly been discussing here.

The broader point is that simply calling something "safe" doesn't tell you enough.

Someone planning to hold a particular bond until it matures may think about a fall in its market price differently from someone who might need to sell it next year.

Risk depends partly on what can happen to your money and partly on what you need that money to do.

Government Bonds and Shares Are Different

If you've read my earlier blogs, What Is the Stock Market? and What Is a Share?, you'll know that buying a share means owning a small piece of a business.

A government bond is different.

You're not buying part of the Government.

When a bond is first issued, investors are lending money to the Government in return for promised future payments.

Shares and government bonds therefore involve different risks and can perform different jobs within a pension or investment portfolio.

It isn't particularly helpful to think of shares simply as "risky" and government bonds as "safe".

The more useful question is why you own them and what job you need them to do.

Final Thoughts

Government bonds can sound complicated. There are gilts, coupons, yields and prices that seem to move in opposite directions.

Once you get beneath the terminology, the basic idea is much simpler.

The Government needs to borrow money.

Investors are willing to lend it.

The bond sets out what the Government promises to pay in return.

That's what sits behind much of the discussion you hear about government bond prices and yields.

You don't need to follow the gilt market every day. But understanding what a government bond actually is makes those headlines a lot less mysterious.

If government bonds form part of your pension or investments, it helps to understand what you own and the job those investments are there to do.

Although the content of the article was correct at the time of writing, the accuracy of the information should not be relied upon, as it may have been subject to subsequent tax, legislative or event changes.

Matthew Birkett
Chartered Financial Planner
Birkett Financial Planning