Last editedAug 20212 min read
Whether it’s to pay debt or invest in infrastructure, governments have multiple tools at their disposal to quickly raise cash. One such option is issuing treasury bonds for investors to purchase. Keep reading to learn more about how UK treasury bonds work, their benefits, and whether this type of investment is right for you.
What are treasury bonds?
Treasury bonds are debt securities issued by the government. Essentially, you’re loaning money to the government by purchasing a bond at a predetermined interest rate. In turn, the government will pay you a fixed interest rate for a set duration of time. When the loan reaches its maturity date, you’re then repaid the bond’s face value.
Because treasury bonds are government-backed, they come at far lower risk than other investment vehicles. Their prices reflect the country’s current economic conditions, including currency strength, rate of inflation, and interest rates.
US treasury bonds vs UK treasury bonds
Many different countries issue bonds. Two of the most traded are US treasury bonds, or T-bonds, and UK treasury bonds, also called gilts. Despite the difference in issuing government and name, the two types of treasury bonds are nearly identical in practice. One thing to keep in mind when comparing bonds from different countries is that their level of risk will reflect the country’s economic stability.
How do treasury bonds work?
No matter the country of purchase, bonds all work in the same way.
The investor purchases a bond with a principal loan amount.
The government makes interest payments to the bondholder at regular intervals.
When the loan expires, the government repays the bond’s face value as well as any outstanding interest.
There are many different term lengths and interest rates to choose from. Treasury bonds are longer term than similar treasury bills. For example, US treasury bonds are always issued in set 30-year terms, while UK treasury bonds can vary between five and 30 years. In fact, the Debt Management Office (DMO) recently released a gilt with a 55-year maturity date. What’s important to realise is that bonds can be bought and sold on the secondary market before their expiry date.
As an example of how this works, imagine that a bondholder purchases a £1,000 gilt with a 5% interest rate for 10 years. They will receive 5% of the £1000 value each year, or a £50 annual rate of return. If they hold onto the bond for the full 10 years, they’ll receive a total of £500 in profit from this investment.
Types of treasury bonds
The type of bond we’ve described above is also called a conventional gilt. These are issued directly by the UK government, with a fixed yield paid out every six months until the gilt expires. However, there’s a second type of bond to be aware of in the UK, called index-linked gilts. These track the Retail Price Index (RPI) with a variable interest rate. As a result, they’re designed to protect your investment from inflation.
There are also a few different ways to purchase bonds:
Bidding at an auction
Purchasing directly from a bank or broker
Purchasing directly from the government
Purchasing on the open market
What are the risks of treasury bonds?
Compared to other types of investments, treasury bonds are relatively low in risk. As with any investment, it’s impossible to eliminate all risk from the equation. Bonds are particularly sensitive to changes in government interest rates. When interest rates risk, bond holding values will fall and vice versa. An additional risk is that of inflation, which reduces your purchasing power and payment value. Interest-linked bonds are designed to combat this risk.
If you’re looking for a way to diversify your portfolio, UK treasury bonds are certainly worth looking at as a long-term investment. Although rates of return are lower than higher-risk options in the stock market, they provide balance to help hedge against losses over time.
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