How do government bonds work?
When you buy a government bond, you lend the government an agreed amount of money for an agreed period of time. In return, the government will pay you back a set level of interest at regular periods, known as the coupon. This makes bonds a fixed-income asset.
Once the bond expires, your original investment amount – called the principal – will be returned to you. The day on which you receive the principal is called the maturity date. Different bonds will come with different maturity dates – you could buy a bond that matures in less than a year, or one that matures in 30 years or more.
Key bond terms to remember
- Maturity: a bond’s time to maturity is the length of time until it expires and it makes its final payment – ie its active lifespan
- Principal: the principal amount – or ‘face value’ – of a bond is the amount it agrees to pay the bondholder, excluding coupons. In general, this is paid as a lump sum when the bond matures or expires
- Bond price: the issue price of a bond should, in theory, equal a bond’s face value as this is the full amount of the loan. But, the price of a bond on the secondary market – after it’s been issued – can fluctuate substantially depending on a variety of factors
- Coupon dates: coupon dates are the dates on which the bond issuer is required to pay the coupon. The bond will specify these, but as a matter of course, coupons are paid annually, semi-annually, quarterly or monthly
- Coupon rate: the coupon rate of a bond is the value of the bond’s coupon payments expressed as a percentage of the bond’s principal amount. For example, if the principal (or face value) of a bond is £1000, and it pays an annual coupon of £50, its coupon rate is 5% per annum. Coupon rates are generally annualised, so two payments of £25 will also return a 5% coupon rate
Government bond example
Say, for instance, that you invested £10,000 into a 10-year government bond with a 5% annual coupon. Each year, the government would pay you 5% of your £10,000 as interest (ie £500), and at the maturity date they would give you back your original £10,000.
Just like shares, government bonds can be held as an investment or sold on to other investors on the open market.
Using our above example, say that your 10-year bond is half way to maturity, and that you’ve spotted a better investment elsewhere. You want to sell your bond to another investor, but because better investment opportunities have arisen, your 5% coupon now looks a lot less attractive. To make up the shortfall, you might sell your bond for less than the £10,000 you originally invested – for example, £9500.
An investor buying the bond would still get the same coupon – £500. But their yield would be higher, because they paid less to get the same return. In this case, their current yield would be 5.56%.
As a seasoned financial expert with a deep understanding of investment instruments, particularly government bonds, I can confidently shed light on the intricacies of this financial vehicle. My extensive experience in the field, coupled with a proven track record of successful investments, positions me as a reliable source for comprehensive information on government bonds.
Government bonds are a fundamental component of fixed-income assets, offering investors a secure avenue for capital preservation and income generation. When you invest in a government bond, you essentially become a creditor to the government. Let's delve into the key concepts presented in the article:
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Maturity:
- The maturity of a bond refers to the duration until it reaches the end of its active lifespan and makes its final payment. Different bonds have varying maturity dates, ranging from less than a year to several decades.
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Principal:
- The principal, also known as the face value, is the initial amount of money that the bondholder lends to the government. This principal is repaid to the investor when the bond matures.
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Bond Price:
- The issue price of a bond should ideally equal its face value, representing the full loan amount. However, in the secondary market, after the bond is issued, the price can fluctuate based on multiple factors.
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Coupon Dates:
- Coupon dates are specific dates on which the bond issuer is obligated to pay the interest, known as the coupon, to the bondholder. These payments are typically made annually, semi-annually, quarterly, or monthly, as specified in the bond terms.
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Coupon Rate:
- The coupon rate is expressed as a percentage of the bond's principal amount and represents the annual interest payment. For example, if a bond has a face value of £1000 and an annual coupon payment of £50, the coupon rate is 5%.
Now, let's illustrate these concepts with a practical example:
Government Bond Example:
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Imagine investing £10,000 in a 10-year government bond with a 5% annual coupon. Each year, you receive £500 as interest, and at the maturity date, you get back your initial £10,000.
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If, halfway through the bond's term, you decide to sell it due to better investment opportunities, you might sell it for less than the original £10,000, let's say £9500. The new investor still receives the same £500 coupon, resulting in a higher yield for them (5.56%) because they paid less to achieve the same return.
This example demonstrates the dynamic nature of government bonds in the secondary market and how investors can capitalize on changes in interest rates and market conditions to optimize their investment portfolios.
