Why and How to Trade With Government Bonds
Reading time: 10 minutes
There are many types of bonds issued by different institutions, but they all work on the same fundamental principle. The bond issuer is the one taking on the debt, and the person buying them, the bondholder, is the one who provides the funds. In exchange for these funds, the issuer pays fixed interest at regular intervals until the bond matures.
Let's say a person bought a bond with a face value of £1,000 and a coupon rate of 5%, which was paid annually for a maturity period of 10 years. This means that the person is lending a sum of £1,000 to the bond issuer for a period of 10 years, during which he or she will be rewarded every year with fixed interest of £50 (= £1,000 x 0.05). At the end of 10 years, the person will get back £1,000, as well as the total amount of interest accumulated over 10 years, or £500 (£50 x 10).
This means the person will receive a total of £1,500 (which is the payback of his or her £1,000, plus £500 in total interest). Government bonds also work on the same principles. Here, the issuer is the government, and the buyer can be any individual wanting to invest in such bonds. They are usually denominated in the country's own currency. Contrary to Treasury Bills (T-bills), government bonds have medium to long-term maturity timeframes, sometimes spanning entire decades.
What are Government Bonds?
Governments have always been the largest issuers of debt. When an investor is buying government bonds, they are lending money to the government for a certain number of years. In return, they receive interest payments at regular intervals on the loan they have given. The face-value of the bond remains unchanged. Governments use this money to support their activities in terms of building up their countries. In the UK, government bonds are termed as "Gilts" or "Treasury-Gilts."
Usually gilts have names like "3% Treasury Stock 2020". This represents the coupon rate, followed by the issuer, and then the redemption date. If the UK government wishes to raise £100 million, it may do so by issuing 1 million gilts, valued at £100 each. This is known as 'Nominal Value' or 'At Par'. Suppose you purchase £1,000 worth of this gilt. You will receive 3% or £30 every year until your £1,000 is returned to you in 2020. There are numerous gilts listed by the UK Debt Management Office.
Some examples include:
- 4½% Treasury Gilt 2019
- 1½% Treasury Gilt 2026
- 4½% Treasury Gilt 2034
What are Gilts?
UK treasury bonds are called gilts. They are debt securities, which means they are debt instruments with a defined notional amount, interest rate, and a maturity date. They are issued by the Bank of England on behalf of Her Majesty The Queen's treasury. In earlier times, these paper certificates used to come with gilded edges, hence the name. There are many types of gilts, such as Index-linked, Double-dated and more (We will cover some of these in greater detail, further down in this article).
Normally, they will all have some common features, such as:
- Principal Value: The amount of debt that the government has taken on, which they will pay interest on.
- Coupon Rate: The interest rate paid by the government to the bondholder. Based on the bond-yield. These coupon rates vary. For example, the interest rate for a UK government bond of 2 years (UK Gilt-2 Year Yield) is 2% (as of September 10, 2018). For UK Gilt 5 Year Yield, it is 0.75%. The coupon is determined by the length of time until maturity. In other words, the further you are from the redemption or maturity date, the higher the rate of interest will be.
- Yield: The annual interest rate divided by the current market price of the bond. It is the rate of return you would receive if you invest in a bond. There are different types of yield calculations.
- Maturity: The date of maturity is the day when the amount you lended to the government will be returned to you.
- Current Market Price: Bonds trade on the secondary market too. Yes, the bond market has a secondary market, where they are traded. They have an inverse relationship with interest rates, and since they pay out a fixed sum of money at regular intervals, it means lower interest rates make them more attractive.
Let's say there's a gilt for a '4.75pc Treasury Stock 2017', and you've purchased £1,000 worth of this. Now let's suppose that in the future the interest rate changes to 3% (from the aforementioned 4.75%). Here's when a 4.75% return will be very attractive. The price of the gilt will rise and become much higher than the £1,000 nominal value. On the other hand, if the interest rate changes to 7% sometime in the future, the coupon of 4.75% will no longer be attractive, and the price of this gilt will decline below the £1,000 level.
International credit rating agencies provide ratings for such bonds, depending on how lucrative their markets are. AAA is usually the highest rating, while BBB or higher are investment-grade bonds. If bonds are rated BB or lower; they are high-yield. Different rating agencies follow different systems to rate bonds. It's useful to know whether a rating agency considers a bond investment grade or below investment grade.
If a bond is assigned an investment grade, it means it represents a low risk of default. S&P's credit ratings for such bonds are denoted by AAA, AA+, AA and AA-. Bonds with these ratings have higher capacity to repay your loans.
Types of UK Gilts
There are several types of gilts in the UK market, here are some of them:
Conventional Gilts: These are the most common type. They are nominal bonds that pay a fixed coupon rate every six months. They have standard maturity periods like 5, 10 and 30 years from the date of issue. At the maturity date, the investor gets paid the principal amount and the final coupon sum.
Index-Linked Gilts: These gilts provide protection against exposure to inflation. The principal payments and borrowing rates are linked to changes in the inflation rate. The coupon rates are adjusted according to changes in the UK retail price index. Coupon payments are made every six months, and on maturity the principal is repaid.
Double Dated Gilts: These were last issued in 2013, and have multiple maturity dates provided by the UK government.
Advantages of Trading Government Bonds
The relation to interest rates and other factors makes government bonds excellent financial instruments for trading. Trading government bonds offers more advantages then simply holding them.
- Short Term Trading: Contrary to holding bonds for long periods of time until they reach maturity, trading will allow you to speculate on their price movements, for short to medium time periods.
- Advantage of Leverage: Don't just put down the full value of the position. Instead, take advantage of leverage to magnify your profits. However, keep in mind that your losses would get magnified with leverage too.
- Take Positions in Rising and Falling Markets: Through CFDs you can speculate on government bonds for both price hikes and declines. Investments in government bonds themselves would only be comprised of losses, if the bond price falls. This is where CFDs would potentially provide an added benefit.
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How to Invest in UK Government Bonds
As we discussed earlier, government bonds are tied to a country's interest rates. A good way to trade them is through bond futures or CFDs, in order to hedge your exposure to interest rate risk. This is because CFDs allow you to take a position in any direction. You can opt to go long or maintain buy positions if the prices are rising. When prices are declining, you can opt to go short or have sell positions.
You will be able to track the minor price movements because of the margins at play. You also have the option of freeing up capital for other investment options. You needn't wait for the bond to mature as you may be waiting to simply realize the interest rate fluctuations that have gone against you. If you are interested in buying UK government bonds, you need to pay heed to certain factors, such as:
- Inflation Rate: Keep track of the UK's inflation rate. Bonds yield a fixed income, and inflation doesn't change that amount. Rising inflation will make that yield less valuable. Additionally, rising bond prices result in weaker yields and vice versa.
- Interest Rates: Coupon rates have to be higher in order to encourage people to invest. If interest rates are on the higher side, government bonds would decline in value.
- Quantitative Easing: The UK has followed a quantitative-easing policy since 2009, making UK gilts an attractive investment option for overseas investors. This means that the BoE has created and re-purchased a large amount of gilts, thereby creating more demand.
- Recession: Bonds thrive during recessions, when interest rates fall. The fixed coupon rates become more valuable in cases of potential deflation.
A good way to keep track of these figures before making any investment decisions is through an economic calendar. Such tools are also available with MetaTrader 4 Supreme Edition (MT4SE). This trading platform allows you to trade CFDs of bond futures and on Forex markets easily. You can also open a demo trading account to start trading virtual funds in a risk-free environment, and test out your strategies, before you proceed to the live markets.
Risks in Bond Investments
Bonds are safe-haven assets. They provide higher income compared with savings, and during times of declining interest rates they are usually less volatile than the Forex and stock markets. High demand for bonds reflects 'flights to safety' by investors. However, they do entail some risks too, such as:
- Market Risk: This pertains to fluctuations in interest and inflation rates. Investors are wary of rising inflation, since bond rates could lag behind increasing prices for years to come. There are inflation-linked gilts or index-linked gilts for such circumstances, in which investors are protected by linking both interest payments and maturity payments to a consumer price index.
- Credit Risk: One of those rare cases where a government chooses to default on its own domestic currency debt, by deciding not to create additional currency.
- Liquidity Risk: Lower demand for bonds makes them difficult to sell when required.
Whatever your choice of investment vehicle, remember that knowledge and market analysis contribute to making informed trading decisions. No investment should be undertaken till adequate risk management has been put in place first.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.