A guide to government bonds and how they work A guide to government bonds and how they work A guide to government bonds and how they work

A guide to government bonds and how they work

Saxo Group

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?

A bond can be defined in simple terms as an IOU. It’s a fixed-income instrument through which an investor (i.e. you) loans money to a borrower (usually a government or corporation). This loan is made through a bond, which is a financial instrument that’s as accessible to individual traders as stocks or ETFs, for example.

Why does a government or corporate entity want a loan?

Bonds are used to finance projects and/or operations. The nature of these projections and operations will vary depending on which entity is borrowing the money. If it’s a government, money raised through bonds could be used to fund a new infrastructure project, such as improving a national road network. Bonds can also be used to pay down government debt.

What do you get in return for lending money?

Financial lenders charge interest on loans. For example, if you borrow money from a bank, you’ll be expected to pay back the loan, plus a bit extra. That “extra” is the interest, which is a percentage of the amount you borrowed. Bonds work in a similar way.

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?

Putting this all together, a government bond is a financial instrument that allows you to “loan” money to the government in return for a fixed rate of interest. In the UK, government bonds are known as gilts. In the US, government bonds are known as Treasuries.

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:

This is when the bond (loan) expires, and the repayment is due. Government bonds can have different maturity dates. For example, you can choose bonds that expire in 10 years or 30 years.

Principal:

This is the face value of the bond i.e. it’s the amount the bond will pay the holder.

Bond price:

The issue price of the bond should match its face value (principal amount). This is because it’s the amount that’s being loaned. However, as we’ll discuss in the next section, you can buy/sell bonds on the secondary market. Prices on the secondary market may not tally with the principal value of the bond.

Coupon dates:

These are the dates the issuer (you as the lender) is required to pay the coupon (i.e. the loan amount). This detail will be defined by the bond, but there are standard coupon dates: annually, semi-annually, quarterly or monthly.

Coupon rate:

This is the amount of interest the bond will return to the issuer (you). This figure is a percentage of the bond’s full amount. For example, if the bond’s value was USD 500 and pays an annual coupon (i.e. interest payment) of USD 50, the rate would be 10% (50 / 500 = 0.1 X 100 = 10%).

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 USD 1,000 with an annual coupon rate of 5%. This means your bond returns USD 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 USD 950.

The terms of the bond stay the same. Anyone that buys it will still receive an annual coupon of USD 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 USD 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 USD 1,000 bond with a 5% coupon rate for USD 950.

Anyone that buys it will be getting a USD 1,000 bond for USD 950, which is a saving of USD 50. Because the original bond is still worth USD 1,000 and the coupon rate is fixed at 5% (i.e. USD 50), the new owner retains these conditions. That means they get a USD 50 discount and a higher yield than the original owner of the bond.

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 USD 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 USD 1,000. If the market conditions weren’t optimal, you might be forced to sell the bond for less than USD 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 USD 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.

If a government is battling massive economic issues or it’s at risk of collapsing, it may not be able to pay its debts. Because of this, you need to check the government’s credit rating. This isn’t any different from a bank checking your personal credit rating before issuing a loan. If a government’s credit rating is poor, a bond will be less attractive than if the rating was strong. You can use credit rating agencies such as Moody’s and Fitch Ratings to see what a government’s risk score is.

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

As we’ve said, government bonds are called gilts in the UK and Treasuries in the US. Bonds can have fixed coupon rates (i.e. interest) or they can move in line with inflation. The latter are called index-linked gilts in the UK and Treasury Inflation-Protected Securities (TIPS) in the US.

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

Government bonds in the US (Treasuries) come in three main forms based on when they mature:

  • Treasury bonds (T-bonds) expire in more than ten years
  • Treasury bills (T-bills) expire in less than one year
  • Treasury notes (T-notes) expire in one to ten years

Do your research and accept the risks

If you’re going to trade government bonds, you need to understand the basics, analyse the market, and accept that you may not make a profit. Government bonds are backed by governments, which does mean there’s a certain level of security with regards to coupon payments and the bond itself. However, once you enter the open market, there’s no guarantee that you’ll buy or sell bonds at prices that realise a profit.

You also now know that various political and economic factors can affect the value of government bonds. If you hold a 30-year bond that was previously desirable due to low interest rates, but inflation starts to rise, your bond may not be as attractive anymore. This is why you have to do your research. Make use of the technical tools and market insights available with your broker; combining these with your own research allows you to decide whether or not it’s worth buying, holding or selling bonds.

Only you can make these decisions based on your own conclusions but, whatever moves you make, it’s important to remember that there’s always a risk. But there also may be rewards. If you can find the right balance and immerse yourself in the world of government bonds, there are intelligent strategies you can use to try to make a profit.

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