What it means
When a government spends more than it collects in tax, it borrows the difference by issuing bonds. Investors hand over cash today in return for a series of coupon payments and the repayment of the face value on a stated maturity date.
Two numbers matter and people constantly confuse them. The coupon is fixed when the bond is issued, while the yield moves with the market price, so if the price falls the same fixed coupon represents a larger return on the money invested, which is why bond prices and yields always move in opposite directions.
Government bonds matter to businesses that will never buy one. Sovereign yields form the base on which corporate borrowing costs, mortgage rates, discount rates in valuations and pension liabilities are built, so a rise in the ten-year yield quietly reprices everything from a factory investment case to a company's own share price.
Risk does not disappear just because the borrower is a government. Holders still face interest rate risk, since prices fall when rates rise, and inflation risk, since fixed coupons buy less over time, while bonds issued by countries with weaker public finances carry genuine default risk on top of both.
Names differ by country and are mostly historical accident. The United States issues Treasury bills, notes and bonds according to length, the United Kingdom calls its issues gilts, and Germany issues bunds, but the mechanics are essentially identical.
In practice
Real-world examples
Example 1
A corporate treasurer with $5,000,000 of surplus cash that will be needed for a factory build in three years buys three-year government bonds rather than leaving the money on deposit. The yield is higher than the overnight rate and the maturity date is matched to the spending date, so market price movements in between do not matter.
Example 2
A pension scheme actuary values the scheme's liabilities using long-dated government bond yields. When those yields fall by half a percentage point, the present value of the promised pensions jumps, and the sponsoring employer is asked for a larger annual contribution despite nothing changing in the business.
Example 3
A finance director building a valuation model takes the ten-year government yield as the risk-free rate, adds an equity risk premium and a company-specific adjustment, and arrives at the discount rate used to appraise a proposed acquisition.
Think of it
Lending money to a government via a bond is like lending cash to the wealthiest, most reliable neighbour on your street. You know they will pay you back with a small thank-you fee because they always honour their debts.
Formula
Calculation
Current yield = annual coupon payment / current market price
An investor buys a government bond with a face value of $10,000 and a 4% coupon, which pays:
Annual coupon = $10,000 x 4% = $400
Interest rates have risen since the bond was issued, so it now trades at a discount, at $9,500 rather than $10,000.
Current yield = $400 / $9,500 = 4.21%
The coupon has not changed, but the buyer earns 4.21% on the money actually spent instead of the headline 4%. If that investor holds the bond for the five years remaining to maturity, they collect five coupons plus the uplift from the discounted purchase price back to face value:
Total cash above purchase price = (5 x $400) + ($10,000 - $9,500) = $2,000 + $500 = $2,500Case study
Seen in the real world
Larkspur Regional Bakery is an illustrative fictional company used to show how a business without a single bond on its balance sheet can still be moved by them. In one year it had a $2,000,000 variable rate loan and a plan to add a second production line.
Over nine months the benchmark government yield rose by roughly two percentage points as inflation persisted. The bank's variable rate tracked upwards, adding around $40,000 a year to interest costs, and the appraisal for the second line, discounted at a higher rate, flipped from marginally positive to clearly negative.
The illustrative moral is about attention rather than investment strategy. Larkspur's owners had never followed bond markets, yet the government yield curve had just decided both their borrowing cost and their expansion, and after that year the yield became a standing item in their quarterly review.
Watch out
Common mistakes
- Believing government bonds cannot lose money. They can and regularly do, because if market rates rise the price of an existing bond falls, and an investor who sells before maturity crystallises that loss.
- Using coupon and yield interchangeably. The coupon is a fixed cash payment set at issue while the yield reflects what you earn given the price you actually paid, and only for a bond bought exactly at face value are they the same.
- Assuming longer bonds are always better because they pay more. Longer maturities are far more sensitive to rate changes, so a small rise in rates hits a 30-year bond much harder than a two-year one.
Questions
People also ask
What does it mean when the yield curve inverts?
It means short-dated bonds yield more than long-dated ones, which usually signals that investors expect rates and growth to fall, and it has often preceded economic slowdowns.
Are government bonds a good place for a company's spare cash?
They can be for money with a known future date, since maturities can be matched to the need, but cash that might be required at any time is usually better held where the value does not fluctuate.
Why do bond prices fall when interest rates rise?
Because newly issued bonds pay the higher rate, so an older bond paying less must be offered at a lower price to give a buyer the same overall return.