Government bond

Definition

A government bond, often referred to as a “sovereign bond,” is a debt security issued by a government to raise funds for various purposes, such as financing public projects, covering budget deficits, or managing economic activities.

What are government bonds?

Government bonds are a form of fixed-income investment, as they provide a fixed interest rate and predictable cash flow to the bondholder over the life of the bond. They are considered one of the safest investment options because they are backed by the full faith and credit of the issuing government.

These bonds are issued by national governments and can be issued by local governments or government agencies. When an investor purchases a government bond, they are essentially lending money to the government. In return, the government promises to pay interest to the investor at regular intervals (usually semiannually or annually) until the bond matures.

Investors, including individuals, institutional investors, and other governments, purchase government bonds as a way to earn a steady income while minimising the risk associated with investing. Government bonds are also used by central banks for monetary policy purposes and by governments to fund public expenditures.

Government bonds have a predetermined maturity date when the government repays the principal amount (the initial investment) to the bondholder. Maturities can range from a few months to several decades.

Why are interest rates on government bonds usually lower than other bonds?

Interest rates on government bonds are usually lower than those on other bonds because government bonds are considered low-risk investments. Governments have a high creditworthiness and a low likelihood of default, making their bonds safer. This reduced risk means investors are willing to accept lower returns compared to other bonds, which carry higher risks due to potential financial instability or default. Additionally, government bonds often have higher liquidity, making them easier to buy and sell in the market, further contributing to their lower interest rates.

Example of government bond

Let’s consider a government issuing a 10-year bond with the following details:

• Face value: £1,000
• Coupon rate: 3%
• Maturity date: January 1, 2034

This means that the government is borrowing £1,000 from investors and will pay them annual interest, or “coupon,” of 3% of the face value. The bond matures on January 1, 2034, at which point the government will repay the original £1,000 face value.

• Annual interest payment: £1,000 × 3% = £30

So, every year, the bondholder will receive an interest payment of £30. At the end of the 10-year period, on January 1, 2034, the government will also return the initial £1,000 to the bondholder.