This explainer looks at government bonds. It unpacks how they work, the market for gilts, the difference between the gilt yield and the coupon rate, and the relationship between the gilt yield and interest rates.
What is a gilt?
Gilts (from ‘gilt-edged securities’) are bonds issued by the UK government. Bonds issued by the US government are usually called ‘Treasuries’ and by the French government ‘OATs’, but they are all government bonds. Governments and companies commonly use bonds to borrow money from the private sector. Governments sell bonds to raise funds to cover the difference between tax revenues and spending. Bonds are essentially an I.O.U or loan between an investor and borrower.
Why do investors buy gilts, and how are they purchased?
Gilts provide a consistent income stream from the investment and are considered one of the safest types of investments. Consistent with this, they have a lower rate of return than higher-risk investments, like bonds issued by companies (which, unlike the UK government, can potentially default) or equities. When the government issues bonds, they are usually sold at an auction, so the market sets the price (and yield). Banks and large financial institutions typically have first access. The banks will then sell them to smaller financial institutions and individuals, though the government can sell directly to individuals.
“Governments sell bonds to raise funds to cover the difference between tax revenues and spending. Bonds are essentially an I.O.U or loan between an investor and borrower.”
The gilts market
Some investors may simply buy gilts at the time they are issued and hold them until they mature. But many others buy and sell them in the secondary market at the prevailing market price, which may be lower or higher than the original price, depending on what happens to market interest rates.
How do gilts pay interest?
When an investor buys a newly-issued bond, they lend the government a certain amount of money for an agreed amount of time, typically 5 to 30 years. In return, the government pays back at a set level of interest at regular periods. Once the bond expires or reaches maturity, the investor receives the face value of the bond. They will also have made interest off the bond throughout that time. The agreed pay-out date can be annual, semi-annually, quarterly, or monthly. The amount paid as the interest on that bond is called the coupon. It is a fixed-interest payment. If a £1,000 bond has a coupon payment of £20 semi-annually, the total annual coupon payment is £40. The coupon rate is the percentage of the annual interest of the face-value of the bond. In this example, the coupon rate would be 4%. The coupon rate is fixed for the life of the bond.
Most gilts function like this – that is, that coupon payments and the eventual repayment are fixed in nominal terms; this means that the coupon rate, as well as providing for a return, also has to compensate investors for inflation. Index-linked gilts are similar, except that both the coupon rate and the eventual repayment are adjusted for inflation. This, in turn, means that the coupon rate can be much lower.
What is the difference between a coupon rate and a yield? Why does this matter?
The difference between a coupon rate and a yield is that a coupon rate is the rate of interest the bond pays annually. In contrast, a yield is the rate of return it generates relative to the market price of the bond at any particular time. Using the same example as before, the coupon rate of the £1,000 was 4%; if the market price of the bond were also £1,000, the yield would also be 4% because the return the bond generated would be equal to the coupon rate.
“Typically, when expectations that central bank rates will go up, the price of gilts goes down because the expected return on holding cash as an alternative improves.”
However, as noted above, there is a secondary market for gilts, at which they are bought and sold at a different price than they were initially sold at. If that £1,000 bond were sold for £800, the coupon payment would still be £40, as agreed in the original purchase, or 4% of the original value of the bond. But the market yield would be 5%.
How does the price of gilts respond to interest rates?
Typically, when expectations that central bank rates will go up, the price of gilts goes down because the expected return on holding cash as an alternative improves. In the example above, the gilt was issued when market interest rates were 4%. Market interest rates, however, mean that if the government wanted to issue a new gilt worth £1,000, it would have to pay a coupon of 5%. Investors don’t care whether they have a new gilt or an old one – they care about returns – so the price of the old gilt, although issued at £1,000, has to fall so that investors get the same return on a new gilt as on an old one.
How does this relate to what is currently going on in the gilt market in the UK?
In September 2022, the Chancellor’s mini-budget announced a costly energy price guarantee scheme and large, permanent tax cuts. Both of these would have increased government borrowing in both the short and long term, increasing the volume of gilts the government would need to sell. Moreover, market expectations of future interest rates were, in any case, already rising sharply, as markets expect the Bank of England to raise short-term rates.
The result was a sharp rise in gilt yields and a fall in gilt prices (as noted above, these are essentially the same thing). This was compounded by particular issues in the market for very long-term gilts, which are typically held by pension schemes. The Bank of England intervened to stabilise this specific part of the gilts market by buying long-term gilts. Following the abandonment of the mini-budget, the gilts market has recovered somewhat.
By Stephen Hunsaker, Research Assistant, UK in a Changing Europe.