What are government bonds?

Government bonds are simply loans that governments take out via financial markets.

The buyer of the bond – normally large institutional investors or professional fund managers – is effectively lending their money to a state for a fixed period of time.  

While bond buyers wait for their capital to be returned, they are paid interest, known as the coupon. Coupons are typically paid twice a year.

Providing the government remains solvent, the amount borrowed, known as the principal, is returned to the investor at a specified time in the future. This is known as the redemption date, or maturity date.

Owning a government bond does not give the holder any control over how a government spends the money or who is in charge. In contrast, owning shares gives you part ownership of a company and allows you to vote on key issues.

There is some jargon in the bond world that investors should be aware of. Gilts are the nickname given to UK government bonds, while American government bonds are known as Treasuries or T-Bills. Bunds are German government bonds, while JGBs are Japanese government bonds.  

Types of government bond

A key difference between government bonds is their maturity dates, with longer-dated bonds considered riskier as investors are potentially locking up their money for longer. This means they usually yield more than shorter-dated bonds.

The key maturity dates are two years, which is considered short-dated; 10 years being medium-term, and 30 years a long-dated bond. Sometimes governments issue extremely long bonds when borrowing conditions are cheap and there is demand from investors, such as Argentina issuing a 100-year bond in 2017.

Bond names show their coupon rate, expressed as an annual yield, and their maturity date. For example, 1½% Treasury Gilt 2047 means someone who invested £100 when this bond was issued would receive £1.50 a year in interest payments from the UK government until 2047, split into two payments each year.

Not all government bonds carry the same risk. Bonds from emerging markets, such as Argentina or Russia, are considered higher risk as there is a greater chance that the government will not pay the interest payments or return the principal. Meanwhile, developed world government bonds, such as those from Britain or the United States, are considered extremely safe.

The risk of a bond is reflected in its yield, with higher yields demanded by investors when lending to risky countries.

Government bonds can also be “index-linked”, meaning that coupon and principal payments change with the rate of inflation. About a quarter of UK government bonds, known as gilts, are index linked.

Their twice-yearly payments, and the principal, are adjusted in line with the Retail Price Index, or RPI. In America, index-linked government bonds are known as Treasury Inflation-Protected Securities, or TIPS.

Inflation-adjusted bonds are used by investors to secure an income that keeps up with inflation, so they don’t end up with a negative “real” income. However, index-linked bond prices are very sensitive to changes in interest rates, so even if inflation is rising then the bonds may not go up in price.

Why invest in government bonds?

Government bonds are important to investors because they are one of the most secure ways to get a fixed income from coupon payments, with a yield that will likely be higher than what they can achieve from cash, whether in a savings account or elsewhere.

Generating a steady return is important for investors wanting to build a balanced portfolio. 

The other key benefit of government bonds, particularly the safest ones, is that because they are viewed as lower risk investments than stocks and shares, they tend to increase in value when events rock the stock market and worry investors. This provides a natural hedge in a portfolio.

Beware though – it doesn’t always work out like this. In 2022, bonds fell at the same time as shares because of an unusual occurrence where interest rates were increased to control inflation despite a slowdown in economic growth.

The bond markets for core government bonds, such as those from the UK or US, are huge and therefore extremely “liquid”, meaning investors can easily buy and sell bonds. This makes them an essential core allocation to bond portfolios.  

How to buy and invest in government bonds?

Direct investments in government bonds are generally reserved for large professional investors, as they are broken down into big investment chunks, but there is also a bond market for retail investors, such as for US and UK government bonds. 

Investors can buy and sell both index-linked and normal US and UK government bonds on the interactive investor platform. 

The complexity of the bond market means most investors prefer to buy a professionally managed active or passive bond fund. An active manager employs teams of credit analysts to figure out how risky a bond is. They also build diverse portfolios and gain access to new issues from leading companies, which retail investors may be excluded from.

What affects government bond prices?

Bonds, like stocks and shares, are traded by investors. Bond prices and bond yields have an inverse relationship, so if bond prices go down then yield goes up, and vice versa.  

The big factor that impacts bond prices are interest rates. This risk-free borrowing rate is set by each country’s central bank. When rates go up, it means that investors can get a better deal from newly issued bonds, and therefore they sell old bonds to lock in a better rate from a new bond.

When rates go down, this has the opposite effect. The old bonds that have higher interest rates become relatively more valuable, so prices go up. 

Longer maturity bonds are more sensitive to interest rate changes, and therefore their prices rise more when interest rates fall, but their prices drop more when rates rise. The sensitivity to interest rates is known as “duration”.

Another factor to watch is economic growth, and the possibility that a government cannot pay back the interest on their bonds. 

While there is next to no chance that safe governments will stop paying interest, the same is not true for the riskier end of the bond market, such as debt from emerging markets. 

UK government bonds versus foreign government bonds

One key consideration when buying bonds is the currency risk. If an investor owns bonds that are priced in euros or US dollars, and pays income in those currencies, then their actual return in pounds is affected by exchange rate fluctuations.

This is particularly important to understand when owning emerging market bond funds, where currencies can be extremely volatile. Emerging markets sometimes issue bonds in “hard” currency, such as US dollars, or in their local currency.

Emerging market bonds issued in dollars carry a greater default risk, however. If a government is in economic trouble, then finding dollars to pay investors can become a challenge, but paying investors in their own currencies can be done by simply printing more money.

Professional fund managers can either use financial markets to eliminate the currency risk via “hedging”, or stick to hard currency bonds to reduce the currency risk.

What are the tax rules when investing in UK government bonds?

UK government bonds, bought directly as individual gilts and not as part of a fund, are free from capital gains tax. This means someone buying and selling a bond, and making money on the trade, will not pay tax on their profits. 

However, bond funds are subject to capital gains taxes when held outside an ISA. 

Unless bonds are held in an investment ISA or other tax-free wrapper products, investors still have to pay income tax on any interest they earn.

If in doubt about tax, seek guidance from a qualified financial adviser.