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

Digital pound likely to launch this decade
Currencies

Digital pound likely to launch this decade

The Treasury and the Bank of England have launched a consultation on the introduction of a state-backed digital pound. We explain how a “Britcoin” cou…
7 Feb 2023
Treasury grills bank bosses over savings rates
Savings

Treasury grills bank bosses over savings rates

The Treasury Select Committee says customers are earning between 0.5% and 0.65% on basic savings accounts, well below the Bank of England base rate
7 Feb 2023
NS&I raises rates on its Green Savings Bonds
Savings

NS&I raises rates on its Green Savings Bonds

NS&I has boosted the rate on its Green Savings Bonds as it plays catch up to the savings market
7 Feb 2023
The best offers for switching banks – get up to £200 free cash
Personal finance

The best offers for switching banks – get up to £200 free cash

Looking to move bank accounts? You can now bag as much as £200 for switching current accounts.
7 Feb 2023

Most Popular

NS&I brings back one-year fixed bonds with highest rates since 2010
Personal finance

NS&I brings back one-year fixed bonds with highest rates since 2010

NS&I’s one-year fixed bonds are back on sale after being pulled off the market in 2019 - but is the rate any good?
1 Feb 2023
The best one-year fixed savings accounts - February 2023
Savings

The best one-year fixed savings accounts - February 2023

Earn almost 5% on one-year fixed savings accounts.
6 Feb 2023
Will energy prices go down in 2023?
Personal finance

Will energy prices go down in 2023?

Wholesale gas prices are on a downward trajectory, but does this mean lower energy bills later this year?
6 Feb 2023