What Are Government Bonds? - Economics Mastery Series

Welcome to the 2025 Economics Mastery Series, brought to you by tutor2u! In this video, Geoff Riley delves into one of the most important topics in A-Level and IB Economics—government bonds. Geoff breaks down complex concepts into manageable insights, helping you understand not just the basics of government bonds, but also their significance in the UK economy and beyond. Whether you’re revising for exams or aiming to deepen your economic understanding, this session is packed with valuable content to help you succeed. Stay tuned for expert explanations, real-world applications, and exam-ready knowledge!

Study Note:

What Are Government Bonds?

• Government bonds are debt securities issued by governments to finance spending and obligations.
• By purchasing a bond, an investor lends money to the government in exchange for:
  • Regular interest payments (coupons) over a set period.
  • The return of the principal (face value) at maturity.

Types of Government Bonds by Maturity

1. Treasury Bills:
   • Short-term bonds (less than 1 year, e.g., 3, 6, or 12 months).
2. Treasury Notes:
   • Medium-term bonds (2 to 10 years).
3. Treasury Bonds:
   • Long-term bonds (10+ years).

Key Features of Bonds

1. Interest Rates:
   • Most bonds pay periodic fixed interest (e.g., a £10,000 bond with a 2-year maturity might pay £400 annually, representing a 4% yield).
   • Yield is calculated as:Yield = (Interest / Market Price) ×100%
2. Credit Ratings:
   • Ratings (e.g., AAA) measure the likelihood of repayment. AAA-rated bonds are considered low-risk.

Why Do Investors Buy Government Bonds?

1. Safe Haven:
   • Seen as reliable, especially in economic uncertainty.
2. Fixed Income:
   • Predictable interest payments, attractive for retirees or risk-averse investors.
3. Portfolio Diversification:
   • Reduces overall investment risk.
4. Liquidity:
   • Easily bought and sold in active markets.

Risks of Investing in Government Bonds

1. Inflation Risk:
   • When inflation exceeds bond yield, real returns are negative (e.g., a 3% yield with 5% inflation results in a -2% real return).
2. Interest Rate Risk:
   • Bond prices drop if interest rates rise. Example: A 10-year bond with a 2% yield becomes less attractive when new bonds offer 4%.
3. Currency Risk:
   • For foreign investors, weaker local currency diminishes returns when converted back.
4. Default Risk:
   • The risk of a government failing to meet obligations (e.g., historical defaults in Greece and Argentina).

Current UK Bond Market Insights (January 2025)

• Rising Yields:
  • Long-term UK government borrowing costs (30-year gilts) surged to 5.22%, the highest since 1998.
  • This poses challenges for funding public projects.

Glossary of Key Terms

Bond

A debt security where an investor lends money to a government or corporation in exchange for periodic interest payments and the return of the bond's face value at maturity.

Government Bond

A bond issued by a government to finance its spending and obligations. Often considered a low-risk investment.

Treasury Bill

A short-term government bond with maturities of less than one year (e.g., 3, 6, or 12 months).

Treasury Note

A medium-term government bond with maturities ranging from 2 to 10 years.

Treasury Bond

A long-term government bond with a maturity of 10 years or more.

Maturity

The length of time before the bond issuer repays the bond's principal amount. Bonds can have short, medium, or long-term maturities.

Coupon Payment

The regular interest payment made to bondholders, typically expressed as a percentage of the bond's face value.

Safe Haven

An investment, like government bonds, that retains value or grows during times of economic uncertainty.

Fixed Income

Regular, predictable payments (interest or dividends) from investments such as bonds.

Portfolio Diversification

The strategy of holding a variety of investments to reduce overall risk.

Liquidity

The ease with which an asset can be bought or sold in the market without significantly affecting its price.

Inflation Risk

The risk that the real return on an investment becomes negative if the inflation rate exceeds the bond's yield.

Interest Rate Risk

The risk of bond prices falling as market interest rates rise, making existing bonds less attractive compared to newer bonds with higher yields.

Currency Risk

The potential for an investment's returns to diminish when the bond’s currency weakens relative to the investor's currency.

Default Risk

The risk that the bond issuer (e.g., a government) fails to meet its obligations, such as paying interest or repaying the principal.

Credit Rating

A rating given by agencies (e.g., AAA) indicating the creditworthiness of a bond issuer. Higher ratings signify lower risk of default.

Gilt

A UK government bond, often considered a secure and reliable investment.

Bond Price

The market price of a bond, which fluctuates based on interest rates and other factors.

UK Government Bond Yield

The effective interest rate that investors require to lend money to the UK government, often used as an economic indicator.