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 pretty impenetrable, despite our best efforts to explain it to This is Money readers. 

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.

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 the ones discussed and watched most closely by financial pundits and people who are outside the industry but take an interest.

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.

What are bond prices and yields?

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.

When yields reach about 7 per cent, there’s a rule of thumb that 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 a few years back, which is why its debts have been the subject of a bitter wrangle between Athens, eurozone officials, the IMF and bondholders ever since.

Spain and Italy’s yields briefly came close to or exceeded 7 per cent at the height of the eurozone crisis, but only temporarily so the threat they would end up like Greece receded.

That said, the referendum in Italy this Sunday might blow up a new euro crisis, and if that happen its bond yields and those of Spain will probably shoot up again.

Change pending: The policies of President Elect Donald Trump are thought likely to spark a bout of inflation after he enters the White House

What has happened to bonds in recent years?

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 has led to yields plunging to record lows, and many financial experts believe a bond bubble has blown up as a result. 

They have long feared a bond crash once central banks start to raise interest rates again, because investors could decide they overbought bonds – both government and corporate – and dump them in a hurry.

A sell-off began in a small way earlier this year and recently accelerated in the expectation a Donald Trump presidency in the US will spark a 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.

This has left existing bond holders sitting on capital losses as their prices drop, although new buyers are now getting 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 as matters stood this week.

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 future.

Take a look at the chart below, which shows the UK yield curve. It illustrates the gap between yields on two and 10-year bonds and how it’s been narrowing and widening over the past year.

Gap between two-year and 10-year gilt yields over the past year: Chart compiled by AJ Bell using data from Thomson Reuters Datastream

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

Right now, the gap is widening and it was at around 1.30 per cent this week. The UK’s two-year bond is yielding 0.12 per cent and the 10-year bond is yielding 1.42 per cent.

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

It narrowed to its smallest point this year on 12 August, at 0.46 per cent. At that point the UK’s two-year bond was yielding 0.14 per cent and the 10-year bond was yielding 0.60 per cent.

When 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.

In the past, the yield on 10-year bonds has sometimes dropped below the yield on two-year bonds. This basically means that investors are demanding higher interest rates to lend the government money on short-term bonds than they are on long-term bonds.

When this happens, experts say the yield curve is inverting. This indicates investors are very worried about economic prospects both immediately and further into the future, so they are rushing into bonds as a safe haven, sending their prices up and their yields down across the board.

See the two charts below for the occasions when this has happened to the UK and US yield curves since 1996. The yield curve inverted – 10-year yields went below two-year ones – before the recessions in 2000-02 and 2007-09.

The curve steepened during the recoveries in 2003-05 and 2009-11, but then flattened as economic growth proved disappointing.

Gap between two-year and 10-year gilt yields since 1996: Chart compiled by AJ Bell using data from Thomson Reuters Datastream

Gap between two-year and 10-year US treasury yields since 1996: Chart compiled by AJ Bell using data from Thomson Reuters Datastream

What does the shape of the yield curve reveal?

A steepening yield curve indicates investor optimism about the economy, a flattening one signals scepticism and an inverting one suggests pessimism, according to AJ Bell investment director Russ Mould.

‘Any steepening of the curve, as long-term interest rates creep up, means the market is pricing in higher inflation and/or a tightening of monetary policy in the form of higher interest rates. This is suggestive of robust future economic growth,’ he explains.

‘The yield curve can also steepen if short-term rates go down, while long-term rates remain unchanged. This is what central banks have been trying to achieve with the quantitative easing programmes as it helps banks’ profitability – they borrow at the lower rate and lend out at the higher one, pocketing the difference as profit.

‘Some argue that this tampering with the yield curve means it is no longer as valuable an indicator as short-term rates are being artificially depressed.’

‘The yield curve can also flatten, either because short-term rates rise as long-term ones remain unchanged, or the yield on 10-year bonds fall faster than those of two-year debt.

‘This tends to reflect market disappointment with growth and expectations that interest rates will go lower as central banks try to boost activity.

Looking ahead: Inflation fears mean investors become unwilling to get locked into bonds at interest rates that could well lag increasing prices

‘The curve is said to be inverted when the yield on 10-year bonds is below that of two-year bonds and this is traditionally seen as a harbinger of recession.

‘For the moment, the yield curve is steepening in the UK as markets look to President Elect Donald Trump and his plans to revive flagging US – and by implication global – growth through corporate tax cuts and infrastructure spending, as well as Prime Minister Theresa May’s similar policies.’

Jason Hollands, managing director of Tilney Bestinvest, says QE has led to flatter curves which has squeezed bank profitability since 2008, at a time when banks faced a number of other pressures.

He explains that this is why bank shares have rallied since curves started steepening in August.

Hollands adds: ‘In the early 1990s, the savings and loans industry in the US was effectively bust; it was a smaller scale version of the wider banking problems now.

‘If you look at US yield curves then, Federal Reserve chairman Alan Greenspan deliberately “manufactured” a steeper curve to help the savings and loan companies earn their way out of their problems. This proved a very neat and successful solution to the problem.’

Is the yield curve a good guide to future economic performance?

‘There is no such thing as an infallible indicator,’ says Mould. He notes that in 2013-2015 the yield curve flattened markedly, but we didn’t get a recession just disappointing growth.

Mould adds that many financial commentators think central bank quantitative easing programmes, which involve buying large quantities of bonds, has made the yield curve less reliable. That’s because a ‘false, price insensitive buyer’ is now in the market.

Hollands says: ‘Above all, changes in the yield curve tell you where investor expectations are moving on the outlook for inflation and interest rates over time.

‘A steepening yield curve can be both an indicator of improving confidence in the economy, but also concerns about inflation so you have to look at what is driving moves.

‘Currently the yield curve is steepening because Donald Trump’s policies are expected to stoke up global inflation, the cost of imports into the UK are rising because of the weak pound and the oil price has leapt this week following a deal between producers to reduce supply.

‘The challenge however is that in recent years, central banks have taken direct actions to shape the yield curve by creating new money and using this to buy bonds in the market to influence yields and keep them low.

‘For example the Bank of Japan has gobbled up around 40 per cent of the Japanese government bond market to keep borrowing costs below zero. In this environment the yield curve reflects attempts to guess what central bankers might do next not just investors’ forecasts for outlook.

‘Yields could rise dramatically if the markets perceive an end to direct interventions in the bond markets.’