What are bonds and gilts? The market explained

The reaction of the bond markets will be closely watched when Labour delivers its first budget, providing the first signs of what investors who lend money to the UK think about Rachel Reeves’s tax and spending plans.
In the aftermath of Liz Truss’s mini-budget in 2022, bondholders dumped UK assets, such as bonds and the pound, en masse, causing major disruption in the financial markets that helped to unseat her as prime minister after 49 days in office. Here’s a guide to how the bond market works.
A bond is a financial instrument issued by a company or a government that acts as an IOU certificate to a lender. Bonds are issued to raise specific sums of money and provide the holders of the IOU with a fixed return, or a coupon, which is an annual interest payment paid out over a specific number of years. Most countries issue bonds whose duration can range from a couple of months to up to 50 years. When the bond expires, or reaches maturity, the issuer pays the creditor the full value.
Bonds issued by the UK government are known as gilts, named after the gilded edges on British bond certificates. US bonds are known as “treasuries” and German bonds are called “bunds”.
• Investors pile into gilts as shares face tax rise
UK government bonds are sold to investors at regular auctions held by the Debt Management Office. These auctions are for large institutional investors such as bond funds, investment banks and pension funds. Pension funds hold about a fifth of the UK’s gilts, most of which have long durations of about 30 years, as they are a safe asset that provides a guaranteed fixed return for a number of years. Retail investors can also invest in bonds directly or through their investment and pension funds.
• UK bond sales expected to hit £300bn this year
Bonds are also traded on the secondary market, where price changes reflect factors such as a shifting interest rate environment, a company’s financial state, or the state of an economy. When bonds change hands between traders on the secondary market, the price at which they are bought and sold is reflected in the yield. Bond yields fall when the price of the asset rises, and they rise when the price of the bond declines.
Yields are a good proxy for a company’s or government’s borrowing costs, as falling yields and high prices can reflect a strong creditworthy borrower, while rising yields can be a dangerous indicator of the borrower’s solvency. Shorter-dated bonds have lower yields as they are less risky to hold than longer dated assets, which are a bet on the future.
A number of factors can drive bond yields up or down. The most significant is inflation and interest rates. When interest rates are high and savers can earn better returns on their cash, bond yields usually rise (and the price of the bond falls). Existing bonds become less attractive to hold as they pay out a constant fixed coupon, which can be lower than rising interest rates.
Higher interest means a higher cost of borrowing for companies and governments. Newly issued debt reflects these rising borrowing costs and pay out higher coupons than outstanding debt. In the sovereign debt markets, two-year bond yields are the most sensitive to interest rate changes.
An economy’s growth outlook can also impact bond yields usually for longer-dated debt of more than ten years. Investors usually sell bonds at lower prices if they are worried about a country’s growth prospects and its borrowing outlook, pushing up yields.
When governments issue more debt this raises the supply of bonds in the market, pushing down on prices if there is no accompanying jump in demand.
UK bond yields have been creeping higher in the run-up to Labour’s budget on October 30, a factor that could worry the chancellor about the viability of her tax and spending plans. However, yields on two and ten-year debt are only at three-month highs and remain at a contained level.
Bond investors will have to make a series of judgments about the budget. If the level of borrowing over the next year increases by the estimated £20 billion, the extra supply of gilts could push down prices and raise yields. If investors think that the budget can succeed in raising the UK’s growth potential, then longer-dated gilt yields could rally.
Bondholders will also have to judge whether Labour’s policy choices will impact inflation, as higher price growth will mean fewer interest rate cuts — a factor that could also keep yields high.