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%.
