How Do Bonds and Gilts Work?

Introduction

The safest investments on earth are generally considered to be the debt obligations of rich and powerful sovereign governments. Among the richest and most powerful are the governments of the United States and Britain. To finance their activities, these governments issue bonds, called "gilts" in England, which pay a modest rate of interest over time and are eventually repaid in full. A Treasury bond or gilt is essentially a loan where the government is the borrower, and their collateral, officially called "the full faith and credit," is essentially its ability to tax or otherwise raise money from its population.

Types

The face value of a Treasury bond is $1,000, though there are purchase minimums for different length maturities. Treasury Bills are issued with 91-day,182-day and 364-day maturities. Treasury Notes are issued in 2-, 3-, 5- and 10-year maturities. Treasury Bonds are issued in 30-year maturities and, like T-notes, pay interest twice a year. Gilts are issued by England at a par value of 100 pounds and have maturity dates similar to U.S. Treasuries. England has a small number of outstanding undated bonds, which exist in perpetuity and date back as far as the eighteenth century. Both the United States and England issue bonds whose yields are linked to the official government measures of inflation. These are called Inflation-Protected Securities, or TIPS in the United States, and Index-Linked Gilts in England.

Market Value

Funding transactions with the government are usually conducted through a limited number of primary dealers who bid for bonds at auction. These dealers then make the bonds available on an open market, where prices and yields are determined market forces. Bonds usually trade for less than their face values, which enhances the yield for the bondholder, because, as the price of purchasing a bond increases, its yield to maturity decreases. The total yield to maturity is the difference between the purchase price and the par value, plus the interest to be paid up to maturity. And, if interest is reinvested, the yield can be even greater. Most bonds are not held to maturity, however, but traded to generate profits on fluctuating market conditions. For example, if prevailing interest rates fall, a bond purchased at a fixed yield may later trade at a higher price and lower yield, resulting in a capital gain for the holder if the bond were to be sold before maturity. Treasury bonds and gilts yield lower interest rates than corporate or municipal bonds because there is a very low perceived risk of default.

Resources

• Gilts and Bonds
• Gilts
• Gilts and Government Bonds