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How to invest in government bonds: the ultimate guide

By Connor Freitas

Here’s a comprehensive guide on how to invest in government bonds – from where they can be bought and sold to the rates of interest they offer

How to invest in government bonds: the ultimate guide

If you want to know how to invest in government bonds, it’s worth looking at the current state of the market first. Government bonds are normally turned to in times of unprecedented volatility – such as the economic uncertainty triggered by the coronavirus pandemic. But investing in government bonds may not always be the best solution for those seeking a respite from the stock markets. Here, we explain how government bonds work, why they’re a common staple in a diversified portfolio and how COVID-19 has affected the market.

Government bonds in the UK: the facts

Government bonds in the UK are commonly known as gilts. They’re released whenever the state needs to raise money for day-to-day expenditure or big infrastructure projects. British government bonds are presented in £100 increments.

Here’s how they work in a nutshell. Let’s imagine that the Government wants to raise £10m – perhaps to construct a shiny new bridge. They would issue 100,000 gilts with a nominal value of £100 each. Interest payments, otherwise known as the coupon rate, are illustrated as an annual percentage.

Let’s imagine that you’re considering purchasing a gilt that’s named “Treasury stock 2 per cent 2025”. For such a short name, it sure packs in a lot of information. It tells us that the coupon rate of these government bonds stands at 2 per cent and that its nominal value will be paid back to the bearer in full come 2025. If Madeleine owned 20 gilts, a total investment of £2,000, she would receive £40 in interest per year.

Most government bonds have a fixed level of interest for the entirety of their term, meaning that they won’t be swayed by fluctuations in the Bank of England base rate. However, approximately 25 per cent of British gilts in existence are linked to inflation. In layman’s terms, this means it is possible to invest in government bonds with a fluctuating interest rate. The returns offered by these gilts are tied to the Consumer Price Index (CPI), which tracks changes in the prices of more than 700 goods and services including clothing, appliances, eating out and air travel.

Both types of government bonds have their pros and cons. Let’s look at charts that compare how fixed interest and inflation-linked gilts could perform over five years.

Jim, who has opted for fixed-interest government bonds worth a total of £2,000, can sleep easy at night knowing that he’s going to get a return of 2 per cent – or £40 – every single year. By year five, he will have earned a total of £200 in interest, and the bond amount will be repaid in full.

Helen has opted for inflation-linked government bonds, and she has invested the same amount: £2,000. Her annual returns will be dictated by the CPI, and although the Bank of England sets a target for a constant level of 2 per cent there can be some variations. She makes nothing in year one, and a modest £14 in year two. But the CPI rate hits 2.7 per cent and 2.5 per cent in years three and four respectively, meaning her annual gains in these periods are above what Jim is getting. When all five years are put together, Helen is £36 worse off than Jim.

Government bonds are popular because they are low risk. Both Jim and Helen can rest assured that the British government is highly unlikely to default on the face value of their gilts, meaning they’ll get their initial sum in full. But this doesn’t mean there aren’t potential downsides.

Jim could be left to rue the day he chose to invest in government bonds with a fixed interest rate. In year three of his five-year commitment, the Bank of England could increase base rates, meaning subsequent gilts offer greater returns. Meanwhile, as we’ve seen in the example, Helen can run the risk of getting no returns whatsoever. A few years of little inflation may be great news whenever she’s going to the supermarket, but it’ll be calamitous for her investments. Tracking down government bonds with the highest returns can be reduced to something of a guessing game, as no one can say with certainty where the British economy will be in five years’ time.

How to invest in government bonds

If you’ve managed to figure out which government bonds to invest in, the next step is to discover where they are sold.

You can invest in government bonds directly through the Treasury, through the snappily named United Kingdom Debt Management Office. However, it’s much more common for government bonds to be traded on secondary markets.

Reflecting how interest rates fluctuate and how gilts issued at different times offer varying returns, it’s possible that a seller may receive more or less than the face value of their government bonds.

Let’s go back to the example of Jim with his 2 per cent gilts. If newer bonds offer 4 per cent returns, no buyer in their right mind would want to pay the full face value of £100. In order to compensate for this, they may offer £90. This means that, although the buyer may receive less interest than the market average, they’ll make an additional £10 in profit when the bond matures. They only paid £90 for it, but the government is going to give them a tidy £100.

It can also work the other way. Now let’s imagine Jim has 4 per cent gilts, but newer ones on offer only deliver returns of 2 per cent. If he chose to sell them on the secondary market, a buyer may be prepared to pay £110 for each gilt – 10 per cent more than their face value. While Jim makes an instant healthy profit, the buyer will benefit from higher interest payments over time. The only remaining challenge is finding a sweet spot where buyers and sellers agree.

Government bonds versus corporate bonds

There’s one more common question that first-timers often face: is it better to invest in government bonds or corporate bonds?

A lot of this depends on their appetite for risk. Corporate bonds can often promise much higher returns than their state-issued counterparts, but investors could end up getting pennies back on the pound if the business goes into default. That said, it’s worth noting that not all governments offer a cast-iron guarantee of repayment.

For an example of this, you only need to look to Greece. The country was left overwhelmed by debt following on from the 2008 financial crisis. Rating agencies downgraded Greece’s bonds to “junk” status, making it exceedingly difficult for the country to raise new capital. The embattled nation needed a bailout from the International Monetary Fund and, years later, would actually miss a crucial debt payment back to the IMF.

Irrespective of whether you’re interested in investing in government bonds or corporate bonds, assessing creditworthiness through the ratings offered by the likes of Standard & Poor’s, Fitch or Moody’s is essential. Higher scores may bring safety, but they’ll also bring lower rates of return. Finding the right investment often depends of reflecting extensively on your attitude towards risk, and whether you’d be prepared to lose your capital in the event of a collapse. With governments around the world embarking on unprecedented levels of borrowing to fund coronavirus stimulus packages, the prospects of a default aren’t as remote as they were just three short months ago.

FURTHER READING: Which is a better investment – stocks or bonds?

FURTHER READING: How to invest in bonds – and whether you should right now

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