Here is a handy explanation of how Government Bonds and Gilts work.
| What are government bonds? A Government bond is a type of investment where you loan money to the Government for a fixed period and in return receive a rate of interest, which is known as a coupon. Once the fixed period comes to an end, you’ll receive the original sum you loaned to the Government. During the bond’s tenure, your money will be used for Government spending on public services or state projects. So, for example, your money could be used to fund the NHS or build a school in an underprivileged area. These types of bonds differ to a traditional savings account through a bank or building society because they are a form of a loan and can be traded on a secondary market. This means that when you buy a Government bond you don’t have to hold it until it matures. If the time is right, you can sell it for a profit or loss. This is explained in more detail later in the guide. |
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| What is the difference between gilts and bonds? It is important to remember that Government bonds are not only issued by the UK Government. In fact, it is a capital raising instrument which is used across the world. In the US, for example, Government bonds are called Treasury bills, Treasury notes, and Treasury bonds. The difference between these will ultimately depend on when the bond will mature. Meanwhile, in the UK, Government bonds are known as gilts. There are generally two types of gilts, Conventional gilts and Index-linked gilts. Conventional gilts are more common, offering you a fixed coupon rate. Index-linked gilts, however, are variable and can change according to the Retail Price Index, a measure of inflation. |
| How do government bonds work? Typically, when you purchase a Government bond you’ll need to make note of several key terms. These include: Principal – This is the original money used to purchase the bond. Therefore it is also the amount the Government owes you when your bond matures. Bond term – This is the period between when the bond is issued and when it expires. For UK gilts, your chosen bond can have a short term, such as one year, or a long term such as 30 years. Coupon – This is the rate of interest earned on a bond. For example, if you purchase a Government bond for £10,000 and it pays £500 in interest yearly it has a coupon rate of 5%. Yield – Since bonds can be sold at any time, the yield refers to the actual return generated. Therefore if you hold this Government bond throughout its tenure its yield will match the coupon. If it is sold midway, then it will differ to the coupon and the yield will be calculated based on the actual price paid for the bond. As mentioned, you can purchase a Government bond from someone else through a secondary market. Secondary markets are typically where you can trade investments that you already own, such as bonds. If you’re selling your bond on these markets, its price will depend on supply and demand. You’ll likely sell your investment at a discount, meaning you’ll sell for less than the principal amount, at par, meaning you’ll receive face value for your bond, or at a premium, meaning you’ll sell for more than what you originally invested. Take this example, you invest £10,000 into a five year Government bond at a fixed coupon rate. Two years into the bond, and you want to sell your bond and look for a better investment. But during those two years, the base rate rose and now there are more attractive options on the market. So, you decide to sell your Government bond on the secondary market at a discounted price of £8,000. While you have taken a loss on this investment, the person buying your Government bond will get the same fixed coupon rate and in three years they’ll receive the full £10,000 on maturity. As a result, the £2,000 profit is taken into consideration when calculating their yield, which is why it will differ to the coupon rate. Naturally, this means bond yields and prices have an inverse relationship. In simple terms, when one number rises the other falls. |
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