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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
-
The 30 house price hotspotsWhile we have seen house prices sliding, these sought-after locations have seen prices jump by at least 5% over the previous 12 months
-
Working parents will be entitled to 15 hours free childcare for two-year-olds from next year
The government has extended free childcare hours to working parents of two-year olds but it won’t be automatic so make sure you don’t miss out
-
What is an investment trust?
Videos “Active” investment funds come in two main varieties, one of which is investment trusts. But what exactly is an investment trust?
-
What is a dividend yield?
Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
-
High earners to pay nearly £2000 more in tax due to fiscal drag
Videos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
-
What is a deficit?
Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
-
Too embarrassed to ask: what is moral hazard?
Videos The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?
-
Too embarrassed to ask: what is contagion?
Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
-
Too embarrassed to ask: what is a marginal tax rate?
Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
-
Too embarrassed to ask: what is stagflation?
Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
