A guide to government bonds and how they work

Government bonds are an interesting investment proposition through which you earn interest by lending money to the government and getting a return on your capital. Though it’s not quite as simple as offering up your cash to the government, the basic premise of government bonds is that it is a loan in exchange for an agreed rate of interest.

For purposes of this guide, a government is defined as the group of people with the power (or legal right) to govern a country or state. 

What is a bond?

Why does a government or corporate entity want a loan?

What do you get in return for lending money?

A government bond pays you a set level of interest at prearranged periods. This payment, with respect to government bonds, is known as the coupon. Because you’re receiving regular payments in return for providing capital (i.e. an asset), bonds are known as fixed-interest assets.

All bonds do expire. Again, just as you’ll borrow money from a bank for a certain period of time, it’s the same with bonds. You get your money (the coupon) back when the bond expires. That means you get regular payments for a set amount of time before the “loan” is fully repaid.

What is a government bond?

How do government bonds work?

Government bonds have specific terms and conditions. These are often set by the owner. We’ll discuss how bonds are issued and sold in the secondary market in the following sections. For now, here are the main terms you need to know when it comes to trading government bonds:

Maturity:

Principal:

Bond price:

Coupon dates:

Coupon rate:

How are government bonds issued?

Government bonds are usually issued via an auction. The government decides it wants to issue bonds up to a certain value in order to fund a project/pay down debt. The government defines the terms of the bonds using the criteria listed in the previous section. The bonds get auctioned off and, in general, get bought by banks or financial institutions.

Very often, this means you’re buying bonds on the secondary market. If the bonds are bought by a financial institution, you can buy them as a retail customer either directly or via an intermediary such as an online brokerage. This process of buying on the secondary or open market means you may pay a premium for the bond.

This is how trading government bonds works. The owner of the original bond can dictate the terms of the sale. They may sell the bond for less than its face value. They might sell it for more. You need to consider the price of the bond and its potential returns before you buy. Similarly, once you own a bond, you can sell it on the open market. Doing this allows you to set the terms of the sale.

Selling bonds on the secondary market

Executing a trade on government bonds gives you a chance to earn pre-agreed interest payments as defined by the terms of the bond. Some traders are happy to stick with these terms and collect coupons until the bond matures. Doing this means you’re treating the bonds as an investment.

But, because bonds are financial instruments, like stocks, you’ve also got the ability to sell them. If you’ve traded stocks, you’ll already understand how this works. You buy shares in a company and then, if you want, sell them on the open market for a price. It’s the same with government bonds. You have the option to sell a bond on the open market for a price. If that price is more than what you paid for the bond (i.e. more than its original value), you’ll make a profit.

Of course, just like all financial instruments, there’s no guarantee that selling your bond on the open market will return a profit. It could, but it’s not written in stone. So, if you are going to trade government bonds, you need to make sure you understand the market and use the tools available to conduct the necessary analysis. The point though is that you can sell bonds on the open market or, if you want, buy bonds on the open market.

Example of selling bonds on the open market:

Let’s look at an example of how and why you might sell a bond on the open market:

You hold a bond worth $1,000 with an annual coupon rate of 5%. This means your bond returns $50 every year. You’re set to hold the bond for 10 years but, after five years, you spot an opportunity that you think could be more lucrative. You want to free up some capital, so you decide to sell the bond.

Because the market has changed and better opportunities might be available, you decide to sell your bond at a discounted price. You’re doing this because you want to free up some capital and you figure that, if the new opportunity is as lucrative as you expect, the gains will offset the loss you’ve made on the sale. So, in this example, you decide to sell the bond for $950.

The terms of the bond stay the same. Anyone that buys it will still receive an annual coupon of $50. The important bit here though is that the new owner’s coupon rate won’t be 5%. As we’ve said, the rate is based on the bond’s value and the coupon payment. Someone that buys the bond for $950 will have a coupon rate (i.e. yield) of 5.26%, instead of 5%.

This is why people trade bonds

That’s one of the main reasons people trade government bonds on the open market. The right bond can provide a better yield over and above the original coupon rate. So, in this example, someone is selling a $1,000 bond with a 5% coupon rate for $950.

Factors that can affect the price of bonds

Government bonds can increase or decrease in value. That doesn’t mean the value of the bond (i.e. its principal) changes. However, the premium you can sell a bond for can change. For example, if you held a $1,000 bond and the market dynamics were such that it was seen as an attractive investment option, you could sell it for more than $1,000. If the market conditions weren’t optimal, you might be forced to sell the bond for less than $1,000.

Some of the factors that can affect the price of government bonds are:

Demand:

Governments determine how many bonds are issued. Even though the supply doesn’t change, demand can change based on various factors, including inflation and interest rates.

Inflation:

Rising inflation is bad news for bondholders. Why? Because payments are made at a fixed rate. The nature of inflation is that money loses its spending power. So, if you get less for $1 in a grocery store today compared to the time you bought a bond, the payment is going to be worth less. You’ll still receive the same amount of money, but it won’t get you as much stuff in the real world.

Interest rates also tend to increase when inflation rises. If you can get more interest on your money from a bank, why would you hold bonds? The answer is you wouldn’t. The key to making money is to find the products that offer the best yield. So, if inflation is high and interest rates surpass the coupon rate of your bonds, it may be time to sell.

Interest rates:

If interest rates are lower than the coupon rate of a bond, that’s attractive for traders. Think of it like this: if a bank offers you a 1% return and a bond offers 5%, which one would you rather put your money into? Interest rates will fluctuate, but there can be times when bonds offer better returns. It’s during these times that it can be better to hold bonds.

Time:

The amount of time left on a bond can affect how desirable it is. The longer the bond has to run, the more interest payments the holder will receive. That’s obviously more attractive. Time also plays into interest rates. Newly issued bonds take into account current interest rates. If the expiry date is 10 years in the future and it looks as though interest rates are going to drop, the value of the bond will increase.

Credit rating:

Government bonds are backed by the government, as their name suggests. This is seen as a cast-iron guarantee because governments are in control. This is why traders often class bonds as low-risk investments. Unfortunately, a cast-iron guarantee isn’t always a cast-iron guarantee.

What to Look for: the types of government bonds you can trade

UK Gilts

Gilts are named according to their term and interest rate. For example, a 1½% Treasury Gilt 2047 means the bond has a coupon rate of 1.5% and expires in 2047.

US Treasuries