Government Bonds

Learning Objective

5.1.1 Know the definition and features of government bonds: DMO maturity classifications; how they are issued

Governments issue bonds to finance their spending and investment plans and to bridge the gap between their actual spending and the tax and other forms of income that they receive. Issuance of bonds is high when tax revenues are significantly lower than government spending.

Western governments are major borrowers of money, so the volume of government bonds in issue is very large and forms a major part of the investment portfolio of many institutional investors (such as pension funds and insurance companies).

UK government bonds are known as gilts. When physical certificates were issued, historically they used to have a gold or gilt edge to them, hence they are known as ‘gilts’ or ‘gilt-edged stock’. The bonds are issued on behalf of the government by the Debt Management Office (DMO).

3.1 Types of Government Bonds

The main types of government bonds that are in issue can be classified as follows:

• conventional;

• dual-dated;

• index-linked; and

• irredeemable.

3.1.1 Conventional Bonds

Conventional government bonds are instru ments that carry a fixed coupon and a single repayment date, such as in the examples used above of 5% Treasury stock 2016 and 6% Treasury stock 2028.

This type of bond represents the majority of government bonds in issue.

3.1.2 Dual-Dated Bonds

These types of bonds will carry a fixed coupon but show two dates, between which they can be repaid.

The decision as to when to repay will be made by the government and will depend on the prevailing rates of interest at that time.

Example

An example of this was 7¾% Treasury loan 2012–15. In this case, the government had to repay the stock in full by 2015 but had the option to do so earlier, starting in 2012. The government was able to issue new bonds carrying a coupon of less than 7¾% during 2012 and so it was able to save money by repaying the bond early and refinancing it with another bond at a lower rate of interest. If general interest rates had been higher, it would not have had any incentive to do this and would have waited until the final redemption date.

Bonds such as these are attractive to governments as they give them flexibility to manage the country’s finances. By contrast, they are not as attractive to investors, as on repayment they may be able to reinvest the proceeds only at a lower rate of interest.

3.1.3 Index-Linked Bonds

Index-linked bonds are ones where the coupon and the redemption amount are increased by the amount of inflation over the life of the bond.

Example

An example is 2½% Treasury index-linked stock 2020. When this stock was issued, it carried a coupon of 2½%, but this is uplifted by the amount of inflation at each interest payment. Similarly, the amount that will be repaid in 2020 is adjusted.

Index-linked bonds are attractive in periods when a government’s control of inflation is uncertain, because they provide extra protection to the investor.

They are also attractive to long-term investors such as pension funds. These need to invest their funds and know that the returns will maintain their real value after inflation so that they can meet their obligations to pay pensions.

3.1.4 Irredeemable Bonds

There are a limited number of government stocks which are irredeemable; that is, they have no fixed repayment date. They are also called perpetual stocks or undated stocks, because they have no set date for the nominal value to be repaid.

Example

An example is 3½% War Loan, which was issued to fund government expenditure during the First World War and which is still in issue.

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Needless to say, the lack of a certain repayment date is unattractive to investors. However, there is a sinking fund, by way of which the government periodically repays a certain amount of its undated stock (selected by ballot).

3.1.5 Gilt Strips

STRIP stands for Separate Trading of Registered Interest and Principal.

‘Stripping’ a gilt refers to breaking it down into its individual cash flows which can be traded separately as zero-coupon gilts. A three-year gilt will have seven individual cash flows: six (semi-annual) coupon payments and the final maturity repayment.

3.2 Classifications

As well as categorising government bonds by type, another common division is by duration, or how many years remain until redemption.

Generally, short-term debt is considered to be one year or less, and long-term is more than ten years.

Medium-term debt falls somewhere in the middle.

The actual classifications change, however, by market. As an example, UK government stocks are classified in terms of the number of years that remain until the nominal value is repaid:

• 0–7 years remaining: short-dated;

• 7–15 years remaining: medium-dated;

• 15 years and over remaining: long-dated.

In 2005, the UK Debt Management Office issued new gilts with redemption dates of 50 years later for the first time. Although these are classified within the banding of 15 years and over, they are referred to as

‘ultra-long’ gilts.

3.3 Primary Market Issuance

Government bonds are usually issued through agencies that are part of that country’s Treasury department. In the UK, for example, when a new gilt is issued, the process is handled by the Debt Management Office (DMO), which is an agency acting on behalf of the Treasury.

Issues are typically made in the form of an auction, where large investors (such as banks, pension funds and insurance companies) submit competitive bids. Often they will each bid for several million pounds’

worth of an issue. Issue amounts are normally between £0.5 billion and £2 billion. The DMO accepts bids from those prepared to pay the highest price.

Smaller investors are able to submit non-competitive bids. Advertisements in the Financial Times and other newspapers will include details of the offer and an application form. Non-competitive bids can be submitted for up to £500,000, and the applicant will pay the average of the prices paid by the competitive bidders.