Too embarrassed to ask: what is a sovereign bond?

Government spending is funded in two ways – taxation and borrowing. When a government borrows money, it issues an IOU called a sovereign bond.

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.  

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.

Recommended

The Federal Reserve wants markets to fall – here’s what that means for investors
Stockmarkets

The Federal Reserve wants markets to fall – here’s what that means for investors

The Federal Reserve’s primary mandate is to keep inflation down, and lower asset prices help with that. So, asks Dominic Frisby – just how low will st…
25 May 2022
Flexible working: don't rush your staff back the office
Small business

Flexible working: don't rush your staff back the office

The government is urging people to get back to the office. But there are good reasons for many small businesses to embrace flexible working.
25 May 2022
Let’s adjust to living with Covid and get Britain back to work
UK Economy

Let’s adjust to living with Covid and get Britain back to work

The Covid-19 era is over, leaving a stagnant and lethargic workforce in its wake. It’s time to wake up, says Matthew Lynn.
25 May 2022
Should you be worried about energy windfall tax proposals?
Energy

Should you be worried about energy windfall tax proposals?

Calls have been growing for a windfall tax on UK oil and gas producers. It's a popular idea, but is it a good one? And what does it mean for investors…
24 May 2022

Most Popular

Everything is collapsing at once – here’s what to do about it
Investment strategy

Everything is collapsing at once – here’s what to do about it

Equity and bond markets are crashing, while inflation destroys the value of cash. Merryn Somerset Webb looks at where investors can turn to protect th…
23 May 2022
Imperial Brands has an 8.3% yield – but what’s the catch?
Share tips

Imperial Brands has an 8.3% yield – but what’s the catch?

Tobacco company Imperial Brands boasts an impressive dividend yield, and the shares look cheap. But investors should beware, says Rupert Hargreaves. H…
20 May 2022
Three high-quality FTSE 100 shares going cheap
Share tips

Three high-quality FTSE 100 shares going cheap

As stockmarkets continue to fall, bargains are starting to appear, says Rupert Hargreaves. Here, he picks three high-quality FTSE 100 shares that are …
23 May 2022