Government spending is funded in two ways. One is taxation. We all pay taxes to pay for public services such as healthcare and to fund benefits such as the state pension. But government spending often exceeds the amount of tax raised in any given year. So the government plugs the gap by borrowing the money.
But unlike you or I, the government doesn’t go to the bank to borrow. Instead it goes to financial markets. In effect, the government offers to write IOUs to investors, who are mostly big institutions such as pension funds.
In exchange for lending money to the government for a fixed period of time, these IOUs entitle investors to an annual interest payment. This payment is usually fixed.
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So the UK government might say that it wants to borrow money for ten years. In exchange, it’ll pay lenders £20 a year for every £1,000 they lend – a 2% interest rate.
These IOUs are called bonds. Bonds are mostly issued by governments and big companies. When companies borrow money in this way, the IOUs are called corporate bonds. When governments do it, the IOUs are called sovereign bonds.
When the UK issues sovereign bonds, they’re called gilts. For the US, it’s Treasuries. For Germany, it’s bunds.
Once issued, these bonds can be traded freely in financial markets. So the interest rate – or yield – on them will rise and fall.
The yield – which represents the return an investor expects to receive in exchange for taking the risk of owning the bond – will vary depending on a wide range of factors.
A credit-worthy country such as the US or UK will generally be able to offer a lower yield – in other words, borrow at a lower interest rate – than a country with a long history of defaults, such as Argentina.
Countries who can issue debt in their own currencies are also at an advantage. Nations with poorer credit histories sometimes issue debt in US dollars to increase the confidence of lenders. However it means that if the local currency falls against the US dollar, the cost of paying the interest on the bonds can shoot up.
To learn more about what influences sovereign bond markets, subscribe to MoneyWeek magazine.
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