After being largely ignored as an investment option this century except by the terminally risk-averse, government bonds are garnering interest again.
And yes, the use of the word “interest” was deliberate because with bonds of all sorts, “interest” or “the coupon” the bond offers is all-important.
Government bonds – known as gilts (as in gilt-edged) in the UK and Treasury notes in the US – are debt securities that typically pay a fixed rate of interest until they are redeemed (i.e. the government buys them back at the issue price).
While it is true that countries will occasionally default on their loans, it is a very rare event and governments will do almost anything in their power to avoid it, if only because a reputation as a country that fails to repay its debts will find it more expensive to raise money the next time (and the next time and so on for decades) they issue bonds. As such, bonds are considered among the safest forms of investments.
Safe does not necessarily mean boring
Being safe does not necessarily mean the price performance will be steady. Basically, the equation works like this:
- prevailing interest rates go up, bond prices go down
- prevailing interest rates go down, bond prices go up
Why is this so?
Well, remember earlier on it was noted that bonds pay a fixed rate of interest? That interest is paid on the issue price of the bond, not the price at which it is currently trading.
So, if we take the example of a gilt issued at £100 with a coupon (interest rate) of 1% due for redemption in 2029, the interest payment each year would be £1, i.e. 1% of £100.
Now, an interest rate of 1% might have been all right in the previous decade but in this decade the yield on the benchmark 10-year gilt has risen to around 2.5%, so that’s the sort of yield investors are currently looking for. For our 1% gilt due 2029 to yield 2.5% for a new buyer, it needs to fall in price to £40 (£1 interest payment expressed as a percentage of the £40 purchase price is 2.5%).
It's actually more complicated than that because in order to calculate the yield of a bond you need to take into account how far away the redemption date is.
A retired bond trader writes: "So if a 10-year 1% bond is trading at £90.00 you are receiving an interest yield of about 1.1% and £10.00 of capital profit spread over 10 years. The way this is traditionally analysed is with redemption yields, which amortises the capital return.
"The significance of this combination of capital plus interest returns is that bonds with short maturities are more stable than long-dated bonds. A bond that redeems in three months that drops price by £1.00 is giving you about 4% extra return. A bond that has 30 years to go (the US long bond) doesn’t give much of a change of capital return for each point of price change, so prices have to be more volatile at the long end to achieve the required yield change."
Inflation is the enemy of bondholders (but not debt issuers)
Why does the prevailing interest rate or yield go up?
In a word: inflation.
So, here the equation is:
- inflation is expected to rise, yields increase and bond prices fall
- inflation is expected to fall, yields decrease and bond prices go down
Even if you are not interested in investing in bonds, the vacillations of the yields on 10-year government bonds tell you a lot about inflation expectations.
The market tends to focus on 10-year bonds but in fact, there are also benchmark yields for short-dated bonds (bonds with redemption dates that fall within the next five years) and long-dated (30 years) bonds and by comparing yields you can get an idea of when the market expects inflation to come back under control, although it should be noted that longer-dated bonds tend to offer higher yields to compensate for holders having to tie their money up for longer before they get their money back.
Of course, inflation rates vary from country to country and thus naturally government bond yields vary from country to country, which tells you a bit about how the market regards each country’s prospects.
Aside from the esoteric aspects of government bond yields, they have a very real effect on everyday life for most people, not least by acting as a reference point for mortgage rates, other lending rates and savings rates, including pension annuities.