Government Bonds Explained
When a government wants to raise money, usually for capital investment in infrastructure or to help support businesses to grow employment, and consequently, a potentially larger tax income, it will issue bonds. These gilts are loans, issued by the UK government, and are securities with a fixed interest; in most cases, they are thought to be an investment that is very low risk. Why? Because it's reckoned that it would be extremely unlikely that the UK government would go bankrupt and therefore not be able to pay back the interest due on the loan or repay the loan in full when it became due. Gilts that are index linked pay interest that's linked to the Retail Prices Index (RPI), so if you are invested in those, their value rises with inflation. As inflation inevitably rises year on year, it's another investment vehicle that could pay off but would depend on the rate of inflation and how well or badly the economy was doing.
Governments around the world also issue bonds for their own borrowing requirements and if you're looking at the possibility to buy government bonds in a country outside the UK, you should do your research either by comparing what brokers can offer you through a broker comparison or by researching how safe a particular country's economy is.
Pros of Buying Government Bonds
Pros of buying include:
- Low risk of default: Government bonds provide a relatively safe haven for the principal you invest and the regular interest you get. You can invest in bonds with different maturities so can look to a long-term strategy or look for shorter term gains that are as safe as can be in what is often a volatile investment market.
- Tax treatment: Depending on where you invest, there can be advantages to holding government bonds. For example, if you directly own UK government gilts, you will incur no capital gains tax for your investment.
The main upside to government bonds of stable economies is the much lower risk of losing your investment. Markets are capricious and if you invest in corporate bonds, of which more later, you expose yourself to greater risk. As has been seen recently in the UK, some large companies – both outsourcing businesses and well-known high street names – have gone under, leaving shareholders uncertain as to whether they will recoup anything.
That's not to suggest you shouldn't look to invest in corporate bonds but you need to be very aware of the potential risks. It's why many investors like to develop a portfolio that will contain a mix of government and corporate bonds so the risk is spread. Government bonds will usually give a steady, if lower return in terms of interest, whereas corporate bonds may provide a significant return on investment or, in the worst-case scenario, little or none.
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Cons of Buying Government Bonds
Cons of buying include:
- Risk of interest rates: Buying government bonds usually involves little or no risk of a default to your loan, but as bonds are traded on the open market, they could lose value if interest rates rise beyond the face value of the bonds. Therefore, if bond prices move in the opposite direction to the way interest rates have gone, the price of the existing bonds drops. However, if interest rates drop, then the value of bonds is likely to rise. With interest rates generally having been held historically low for many years, you would not expect there to be much change in the immediate future.
- Unexpected surprises: Though bonds are generally reckoned not to be at risk of default, there can be shifts in markets of specific bonds – especially in US municipal bonds – that could default, so take care when choosing your investments.
When you buy government bonds, you are entering as close to a risk-free investment environment as you can, though if you choose to invest in bonds with governments that may not be economically or politically secure, you could have a higher risk to your principal investment. Even though the interest rate may be high in relation to a safer place for your money, you should consider if you are willing to take on those risks. By developing your trading strategies with an experienced broker, you can decide your own risk appetite to build up a diverse investment portfolio.
Corporate Bonds Explained
The difference between deciding to buy government bonds and corporate bonds is in the element of risk you are prepared to take in your investment plans. You know there is considerable security in buying government bonds, but as a relatively low risk investment, you will not get particularly high returns in terms of interest on the principal loan you make. It's a reason why you should consider adding investments into corporate bonds as part of a portfolio that will include the relative security of government gilts and a more risky exploration of the stock market.
When a company, large or small, wants to raise capital for development, or sometimes to provide a cash injection for restructuring, it will issue corporate bonds. If you are thinking about diversifying your portfolio, you should take time to research how the stock market works. When you buy shares in a company, you own a small part of it, unless you are a massive institutional investor, such as a pension fund, that has a huge stake in the company and may have considerable say in how it moves forward in the future. Nevertheless, you have bought in and if you have done your research well, with professional support from a broker, you could make a good return. You can make solid investments with popular industry companies or take a gamble on a start-up tech company. Always remember that it's your money at risk and don't invest more than you can afford to lose.
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How Gilts and Corporate Bonds Work
Sometimes, the technical aspects of how specific investments work can get blurred and are not easily understood, especially if you are relatively new to investing.
If you take a conventional UK gilt, it could state: “Treasury stock 3% 2020”. So what does that mean? The Treasury part is the UK government and it wants to raise £100 million, so it would issue one million gilts that cost £100 each, called the ‘nominal value' or ‘par'. If you bought £1,000 of this Treasury stock, you would receive £30 every year (3%) until the original loan of £1,000 was repaid in 2020. The income you get – the “income yield” – would be paid twice a year. £15 every six months may not sound a lot but if you have much more to invest in a government bond and want a safe haven for your money with a guaranteed return, it's worth considering it as a choice.
With corporate bonds, you're in a position where there is a much higher risk for your investment and it can be determined by the redemption date of your loan to the company. The further away that date is, the higher the interest you will receive, because you have to wait longer for your repayment. Moreover, as a higher risk investment compared to government bonds, you can expect to get a higher interest rate.
Can you Buy Gilts on the Secondary Market?
Yes, the secondary market is an important source when you want to buy gilts or corporate bonds. Gilts are issued in the UK by the government's Debt Management Office, so that may be your first port of call if you want to explore investing in the gilts market. However, you will find that most gilts, other government bonds and bonds from corporations can be traded on the secondary market. As with any trading on a secondary market, you should investigate what the options are. Values of all these types of bonds fluctuate due to interest rates and the solvency of who is issuing the bonds. When interest rates are low, as they have been for many years, bond prices will rise. They will beat the short-term rates that banks offer because the bond interest rates are fixed.
- Government’s Debt Management Office issue Gilts
- Gilts are tradeable on the secondary market
- Interest rates are fixed
As an example, you could pay £95 for a bond, whether it's gilt, corporate or capital, that has a nominal value of £100. You would thus make a capital gain on maturity because the loan will be repaid at the nominal value of £100. If, however, you bought at £105, you would, on maturity, lose out, as you would again be repaid at the nominal value. Always look at the detail when you are considering buying any type of bond.
Buying Options for Gilts and Other Investments
The government's Debt Management Office is the major place to go to for buying government bonds but it's sensible to research a government bonds guide to get a feel for how brokers can help you make decisions about what bonds to invest in and the various maturity dates that are offered. It will depend on your own investment strategy and how you want to work on a diverse portfolio that may include the lower risk options. Corporate bonds can be bought from the Retail Bond Platform through the London Stock Exchange, and you would need a minimum investment of £1,000. Buying a corporate bond does not give you a stake in the company you invest in but makes you a creditor, so you rank above shareholders should the company become insolvent.
With UK gilts, you are well protected in terms of your investment, and although your returns may not be spectacular, you can usually expect them to be reliable in terms of income from interest and the repayment of the loan at the end of the contract. As a corporate bondholder, you are in a better position to recover a significant amount of your invested capital should a company go under.
Government Bonds – A Good Investment Strategy?
Investing is rarely risk-free. You could put all your cash into a bank's savings account and watch a very low interest rate effectively eat your money away as inflation takes its toll. Government bonds, especially UK gilts, may not be completely free of risk but are as secure a way to get some growth for your money as anything else. It depends on what you are looking for. Long-term growth, depending on maturity dates of investments, can provide a reasonable return, and you can be as certain as possible that your principal will be returned as well, allowing you to decide where to invest it for the next stage. Explore a range of options, talk to brokers or investigate online and see what your best options might be. A diverse portfolio that includes gilts gives you that mix of low and high risk options, all of which could make your money grow.