How do government bonds work?

Global government bond markets are vast and affect everyone who pays tax, saves into a pension or invests for the future.

Unfortunately, it’s often hard to tell what’s going on when there’s a surge in bond buying, or a sell-off, because the jargon used by industry insiders can be impenetrable. 

We decode some of the key terms below, to make it easier to understand why the UK Government is suddenly paying more or less interest on its debts on our behalf, and what that will mean for the ordinary investors and big institutions lending it money.

Government debt: Bonds issued by the UK are typically called gilts, which refers to the gold-edged paper that physical bonds were issued on in the past

Another reason to follow what is happening in bond markets is that financial players watch them closely as an early warning indicator for the economic outlook, both at home and abroad.

It’s not a surefire way of predicting growth or recession – nothing ever is – but we explain how this is done below.

What are government bonds?

Governments around the world issue bonds in order to borrow money to help pay their bills. Investors, including banks, insurers and pension funds as well as individuals, buy them in order to earn a return.

Rather than simply calling them ‘UK government bonds’, ‘US government bonds’ and so on, they are often referred to by nicknames or abbreviations.

Don’t worry about why, it’s enough to know that when people talk about gilts, that’s our government’s debt. US bonds are called treasuries, German ones are bunds, French ones are OATs and Japanese ones are JGBs.

Governments issue bonds with a range of different maturities – three months, a year, 10 years, 30 years and so on. This is the length of time governments are giving themselves to pay back investors.

Short-dated bonds are those that mature fast, and in normal times are deemed less risky as a result. Long-dated bonds are those where investors have to wait a while to see their money again, and are regarded as riskier because there is more time for things to go wrong.

Bundestag in Berlin: German bonds are called bunds and are considered among the safest in the world, since the government is so unlikely to default on its debt

Ten-year bonds are usually the ones watched most closely by financial pundits and people who are outside the industry, but take an interest. However, two-year and 30-year bonds often come in for scrutiny too. 

While bonds are maturing, governments pay interest, called the coupon, to investors. At the end, they pay everything back, assuming they don’t default, meaning they are effectively bust. In the meantime, bonds are bought and sold in the massive global market for government debt. Bond prices are the cost of bonds, or what investors pay to buy the debt.

Bond yields are a measure of the annual return to investors who buy government debt. The yield is the interest rate, or coupon, that you earn for holding the bonds.

Bond prices and yields move in opposite directions. When prices move up, yields fall, and vice versa.

Which directions they are going in is basically down to the level of demand for bonds in the market at the time. When there is strong appetite for bonds, because people see them as a safe haven for example, their prices rise and governments get away with paying less interest on their debt via lower yields.

When there is a bond sell-off, because people think they can get a better return from stocks for example, their prices fall and governments end up paying higher interest to attract investors via a better yield.

The rule of thumb is that when yields reach about 7 per cent they become unsustainable, because at that point governments have to pay so much interest to service their debts that they will never be able to pay everything back. 

Greece’s bond yields soared well above 7 per cent during the eurozone debt crisis, when its indebtedness became the subject of a bitter wrangle between Athens, eurozone officials, the International Monetary Fund and bondholders. 

The US is the world’s largest economy, with the most powerful central bank, so its bond yields are watched most closely of all

What has happened to bonds since the financial crisis in 2008?

Government bonds are considered a relatively safe investment compared with stocks and corporate bonds – which means company rather than government debt – and are held as a form of ballast in many portfolios and pension funds.

High demand for bonds reflects an investor flight to safety, which is what happened after the financial crisis in 2008.

They provide a higher income than savings at a time of rock bottom interest rates, and are perceived as less volatile than shares.

After the financial crisis, central banks started making heavy purchases using newly-printed money under their quantitative easing programmes, to support and stimulate faltering economies, which boosted demand for bonds even further.

All this led to yields plunging to record lows, which prompted fears of a bond bubble and many warnings over the years.

A bond crash occurred after the pandemic and Russia’s invasion of Ukraine led to a nasty bout of inflation.

Inflation fears mean investors become unwilling to get locked into bonds at interest rates that could well lag increasing prices over the years to come.

So, investors decided they had overbought bonds and dumped them in a hurry as central banks started to raise interest rates to curb inflation.

The bond sell-off saw prices plummet and yields rise, leaving existing bond holders sitting on capital losses but creating opportunities for new buyers, who can come in at lower prices and get higher yields. 

What can bond market moves tell us about the future?

Financial experts watch government bond markets closely because they help explain investors’ attitudes to current events and risks. They might even foretell what will happen in future – such as an economic boom or a recession.

Bond watchers do this using an important and revealing indicator called the yield curve, so it’s worth learning how this works and decoding the confusing jargon surrounding it.

What is the yield curve? 

At its simplest, this shows what yield you are getting for bonds with different maturities at a single point in time.

Take a look at the yield curve below showing the yields on gilts of different maturities.

Usually the yield or interest rate will be lower on bonds with shorter maturities because it’s not long until investors get their money back, so they see them as less risky and will accept a lower return.

However, the yield tends to be higher on bonds with longer maturities like 10 years because there is more chance of things going wrong, so investors see them as more risky and want a better return.

We can see that is the current situation from this chart.

UK yield curve: Chart compiled by AJ Bell using data from Thomson Reuters Datastream

This yield curve is of little interest on its own. What people want to know is how it is changing over time.

One way to analyse the yield curve is therefore to look at the gap between yields on bonds with different maturities – two and 10-year bonds can be used for this purpose.

The reason to look at the size of the gap between these two yields, and whether it is widening or narrowing over time, is to gauge investors’ reading of levels of risk now and in the future.

What is happening when the 2-10 yield curve steepens, flattens or inverts? 

The important thing always to keep in mind here is that normally long-dated bonds are regarded as riskier so the yield on them should be higher, and shorter dated ones are thought to be safer so their yield should be lower.

When the gap between their yields is widening, and the line of the yield curve is therefore going up, experts say it’s steepening. 

This is deemed to be a sign that an economy is expanding, inflation expectations are higher, and interest rate rises might follow.

If the gap is narrowing, and the line of the yield curve is therefore going down, financial experts say it is flattening. This bit of jargon is misleading because it implies a flat line, but actually the line is going down.

This is taken as an indicator of future economic stagnation or even contraction, that inflation expectations are dampened, and that interest rate cuts might follow.

In the past, the yield on 10-year bonds has sometimes dropped below the yield on two-year bonds, which is when the yield curve is inverting.

That means investors are demanding higher interest rates for loaning a country money in the short term than they will over the long term.

This breaks their usual practice of regarding debt that is going be repaid quickly as the safest and reflects a distinct lack of confidence in that country’s near-term economic health.

When you see alarmed headlines in the financial press about a yield curve inversion, this indicates investors are very worried about economic prospects – it can be a harbinger of recession.

The US is the world’s largest economy with the most powerful central bank, and its bond yields are watched most closely of all.

So take note if you hear about the yield or return from 2-year US government bonds – known as treasuries – getting higher than the yield from US 10-year bonds, and causing a yield curve inversion.

This is what market experts are talking about when they use jargon like ‘the 2-10 year inversion’.

When this happens, investors rush into bonds as a safe haven, sending their prices up and their yields down.

This post first appeared on Dailymail.co.uk