Without knowing it, many of you could be invested in Government bonds. Whether it be through a workplace pension or a self-researched investment fund, some of your investments could be backing state-led projects.
This is because many Government bonds, issued by countries with stable finances, are low-risk investments which can add security to your portfolio.
So, what are Government bonds and how is your money being invested? In this guide we’ll also explain how Government bonds work and whether they are tax-free.
A Government bond is a type of investment where you loan money to the Government for a fixed period and in return receive a rate of interest, which is known as a coupon. Once the fixed period comes to an end, you’ll receive the original sum you loaned to the Government.
During the bond’s tenure, your money will be used for Government spending on public services or state projects. So, for example, your money could be used to fund the NHS or build a school in an underprivileged area.
These types of bonds differ to a traditional savings account through a bank or building society because they are a form of a loan and can be traded on a secondary market. This means that when you buy a Government bond you don’t have to hold it until it matures. If the time is right, you can sell it for a profit or loss.
This is explained in more detail later in the guide.
It is important to remember that Government bonds are not only issued by the UK Government. In fact, it is a capital raising instrument which is used across the world.
In the US, for example, Government bonds are called Treasury bills, Treasury notes, and Treasury bonds. The difference between these will ultimately depend on when the bond will mature.
Meanwhile, in the UK, Government bonds are known as gilts.
There are generally two types of gilts, Conventional gilts and Index-linked gilts. Conventional gilts are more common, offering you a fixed coupon rate. Index-linked gilts, however, are variable and can change according to the Retail Price Index, a measure of inflation.
Typically, when you purchase a Government bond you’ll need to make note of several key terms. These include:
As mentioned, you can purchase a Government bond from someone else through a secondary market. Secondary markets are typically where you can trade investments that you already own, such as bonds.
If you’re selling your bond on these markets, its price will depend on supply and demand. You’ll likely sell your investment at a discount, meaning you’ll sell for less than the principal amount, at par, meaning you’ll receive face value for your bond, or at a premium, meaning you’ll sell for more than what you originally invested.
Take this example, you invest £10,000 into a five year Government bond at a fixed coupon rate. Two years into the bond, and you want to sell your bond and look for a better investment. But during those two years, the base rate rose and now there are more attractive options on the market.
So, you decide to sell your Government bond on the secondary market at a discounted price of £8,000. While you have taken a loss on this investment, the person buying your Government bond will get the same fixed coupon rate and in three years they’ll receive the full £10,000 on maturity. As a result, the £2,000 profit is taken into consideration when calculating their yield, which is why it will differ to the coupon rate.
Naturally, this means bond yields and prices have an inverse relationship. In simple terms, when one number rises the other falls.
Unlike the stock market, where dividend pay-outs can fluctuate, opting for a fixed income Government bond can give you a degree of certainty on how much your investment will earn.
So, one of the biggest risks with Government bonds is that you need to be comfortable that the state won’t default on its debt.
This has happened before. In 2012 Greece defaulted on its debt and, according to credit rating agency Moody’s, most investors agreed to lose 70% of what they were owed by the Government. However, this is a very rare occurrence.
Remember, schemes like the Financial Services Compensation Scheme don’t cover investments in Government bonds. So if a country is at risk of defaulting on their payments you will more than likely be left short.
This depends on your appetite for risk.
The UK, for example, has never defaulted on its principal or interest payments on its gilts, and is therefore seen as a safe investment.
However, for this perceived lower risk, UK gilts typically pay less than other countries offering similarly structured Government bonds.
This could be enticing but remember to be confident in the Government’s ability to pay you back.
One way to evaluate the creditworthiness of a country is to keep an eye on its credit rating, which is issued by Moody’s, Fitch, and Standard & Poor. The higher the credit rating, the more likely that the Government will pay back its debt.
Remember, you can buy bonds from many different countries. UK gilts aren’t only available to British investors, and the same goes for some other Government bonds.
As a private investor, it can be difficult to buy UK gilts directly from the Debt Management Office (DMO). This is because it only offers this investment to those on the DMO’s Approved Group of Investors.
This means you’ll most likely be buying UK Gilts on a secondary market, which is available through various investment platforms such as our preferred investment platform interactive investor.
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No, interest on gilts is subject to income tax like other investments in the UK. Tax laws surrounding these investments are complicated and warrant a separate article itself. That’s why Moneyfacts recommends you speak to a tax specialist for additional questions.
However, it is worth noting that if your Government bond is held within an ISA the interest payments will be tax-free.
As laid out, there are two ways you can lose money by investing in Government bonds.
Firstly, if you hold your bond until maturity the Government could default on its debt where you might not recover your entire investment.
Secondly, if you sell your bond on a secondary market at a discount it could result in a loss.
Traditional Government bonds aren’t Shari’ah compliant. This is because it pays a yield or coupon instead of an expected profit rate.
However, the UK does accommodate for Islamic investors by offering a Sukuk, a type of Shari’ah compliant bond which is set to expire in 2026. This works differently to a bond in that the UK Government sells a financial certificate to an investor and makes a contractual obligation to buy back this certificate on maturity.
Therefore, during the investment term, the investors will own assets under this financial certificate and enjoy its periodic profit instead of coupon rate.
For an alternative Shari’ah investment, consider a Shari’ah savings account. To view the best offers on the market, visit our charts.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.