An investor’s guide to government bonds

In simplistic terms, government bonds are IOUs issued by a national government. In exchange for your cash, you can earn a regular fixed rate of interest, which is sometimes referred to as a coupon. And when the bond has reached the end of its lifespan, also know as when it ‘matures’ you can get your money back (unless the government defaults).

You can typically buy and sell government bonds like you can shares, and their perceived value depends overarchingly on the stability of the government and country which is selling them. For example, a US government bond will be considered safer than an Argentinian government bond. This is reflected in the price and the yield on offer.

UK government bonds, also known as gilts, are largely regarded as having low credit risk because of the unlikelihood that the UK government would default on its debts.

That’s not to say a default won’t ever happen, but it’s currently considered extremely unlikely. According to the Debt Management Office (DMO), the UK government has never failed to make interest payments on gilts¹.

Why invest in government bonds?

In very broad terms, it can come down to two things – a perception of safety and predictability.

A benefit of investing in government bonds from developed and stable economies, aside from the idea of being safe, is for the income they generate. The set level of interest paid can be attractive for income-seekers, particularly in retirement. Or for investors who want to grow their wealth, they can reinvest the coupons to boost growth. However, bonds with low income can still be attractive to investors if they provide a decent yield.

Diversification is another key benefit and an important reason for considering the asset class alongside other investments. In times of market uncertainty, a developed market bond like a gilt, can provide some protection and stability, and help to reduce the volatility of a portfolio as a whole.

However, it depends what is driving the market wobbles. In 2022 when inflation soared and economic growth was weak, bonds performed badly alongside shares.

Risks

It’s important to understand that government bonds aren’t bullet proof.

Broadly speaking, when interest rates change, the fixed rate of income or coupon on offer (from a bond) won’t budge.

However, the bond price will change which impacts the value of your investment.

When rates fall bond prices rise and therefore the yield goes down which makes them less attractive. However, the exact opposite is true when interest rates rise as bond prices fall, yields rise, and bonds become more attractive.

This means existing investors are missing out on higher rates having locked into a bond yield beforehand. That’s not to say you shouldn’t hold government bonds when rates rise, as they can still have a role to play.

Bond holders also suffer during periods of inflation because the real value of the income – in other words, the income adjusted for inflation – diminishes.

Equally, the interest rate, or yield, available from gilts (or similar) isn’t ground-breaking. As is the case with investments across the board, you need to take on more risk to achieve potentially higher returns.

When it comes to debt, there are various ways to do this – either via a bond from a government that is considered unpredictable, or via a corporate bond, which are bonds issued by companies rather than governments. The latter can be relatively safe but are considered riskier than something like a gilt because companies are more prone to collapse than national governments.

Equally, not all corporate bonds are the same. The quality will depend on the company in question. Some so-called ‘high-yield’ bonds, offer a higher rate of interest but they come with much more credit risk and are often referred to as ‘junk bonds’.

But a loan to a stable government with a strong economy could help with the overall balance of your portfolio if you already hold other riskier types of investment.

Tax matters for gilts

If held outside of an ISA, then the income from UK government bonds is liable for income tax, though any profit made from a gilt when you sell or when it matures it is free from capital gains tax.

This 2024/25 tax year has seen the capital gains tax exemption – the amount of capital gains you can make without being taxed – cut from £6,000 to just £3,000. So, for higher rate taxpayers who have already used up their £20,000 ISA allowance, gilts could be worth considering.

Gilts held in an ISA or a Self-Invested Personal Pension (SIPP) won’t trigger income tax (or capital gains tax), however.

What happens at maturity?

When the government bond comes to an end your original capital should be repaid in full (assuming there’s no default). The duration of a bond, as it’s known, can be from three months to as much as 50 years.

If you hold your gilt or bond within an ISA or Self-Invested Personal Pension (SIPP) your maturity cash will remain within the account and is therefore protected from tax unless you decide to withdraw.

You then have a decision to make on what to do with that money. If you want that money to be retained in your investment portfolio you can look to reinvest in fixed income – either government or corporate – to maintain the original balance of asset classes.

Time to reinvest

If you’re looking to reinvest into another bond or gilt, you may be interested to see the 10 most popular gilts and bonds purchased by our customers in the last month.

Investors can also choose to hold a portfolio of gilts by investing in a bond fund, rather than buying individual bonds.

A bond fund could be managed by a manager who will choose the bonds in which to invest, or you can invest via a tracker or an Exchange Traded Fund (ETF) which tracks an index of government bonds.

Another way to access bonds is to select a Ready-made Investments managed and run by our team of investment professionals, so you benefit from their expertise, knowledge, and research. There are five Ready-made Investment funds, with each rated according to their risk level making it simple to pick the one that’s right for you.

All the Ready-made Investment funds, consist of a mixture of bonds, shares and cash, the proportion of which is different in each fund.

It’s worth noting that gains via funds are not free from capital gains tax, unless held in an ISA or SIPP.

Overseas government bonds

It’s not only the UK government that issues bonds. In the US, government bonds are known as Treasury bills, or T-Bills, T-notes or T-bonds (depending on their duration), while German federal bonds are referred to as bunds.

Emerging market government bonds are available too, although most are regarded as much higher risk because many governments are typically less financially stable than governments in developed countries. International or overseas bonds are currently not available on Smart Investor.