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GOVERNMENT BOND INVESTING

Investing can be a risky business and how you decide to invest will depend on what your appetite for risk is. Government bonds are generally considered to be a lower risk option than investing in the stock market or through corporate bonds. You can buy UK government bonds – known as gilts – through UK stockbrokers, fund supermarkets or by going directly to the government’s Debt Management Office. Governments sell bonds to raise money and they are generally fixed interest securities designed to pay out a steady income.

  • Government bonds explained
  • Pros and cons of buying government bonds
  • Investing in bond funds
  • Corporate bonds explained
  • Government Bonds Explained

Steve Miley

pro MEMBER SINCE 2018

Steve has 29 years of financial market experience including 3 years at Credit Suisse and 15 years at Merril Lynch. Steve is the Academic Dean for The London School of Wealth Management and has won many awards from Technical Analyst Magazine.

10 min read 26th of Jun, 2018
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GOVERNMENT BOND INVESTING

When a government has a budget deficit and has a borrowing requirement it will issue bonds. These bonds are known as gilts in the UK and are loans issued by the government, securities with a fixed interest. In most cases, they are thought to be an investment that is very low risk. Why? Because it is assumed 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.

GOVERNMENT BOND INVESTING

Gilts that are index linked pay interest that's linked to the Retail Prices Index (RPI), so if you invest in those, their value changes with inflation. As inflation tends to be positive 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.

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Advantages 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 relatively safe.
  • 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 on your investment.

The main upside to government bonds of stable economies is the much lower risk of losing your investment. Markets can be volatile and if you invest in corporate bonds, of which we will look at later, you expose yourself to greater risk. As has been seen perviously in the UK, some large companies have gone under (become bankrupt), leaving bond holders and 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 more significant return on investment.

Disadvantages 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, as 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.
  • 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 investing and trading strategies with an experienced broker, you can decide your own risk appetite to build up a diverse investment portfolio.

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Corporate Bonds Explained

When deciding to buy government bonds or corporate bonds, the decision is very much about the amount 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 may consider adding investments into corporate bonds as part of a portfolio, that will include the relative security of government gilts and a riskier exploration of the corporate market.

When a company, large or small, wants to raise capital for development, or sometimes to provide a cash injection for restructuring, it may issue corporate bonds. If you are thinking about diversifying your portfolio, you should take time to research how the corporate bond market works. When you buy bonds in a company, you have loaned the company capital. 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 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.

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% 2030”. 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 2030. 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.

Corporate Bonds Explained

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 bond prices will be higher. 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.

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Buying Options for Gilts and Other Investments

The government's Debt Management Office is one 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.

Conclusion:

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. 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.

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