What are bonds and gilts? The market explained

Most chancellors, when they stand up to deliver their budget, worry about how their tax and spending plans will go down with the voters who elected them.
But when Rachel Reeves stands up in parliament on Wednesday the stakes are much higher than just electoral popularity.
The chancellor knows that she will have to persuade not just the public that her plans are sensible but, more importantly, the international bond markets, where cash is effectively lent to the government to fund its spending.
Two years ago Liz Truss’s nascent premiership collapsed after bondholders took fright at the unfunded tax cuts paid for by borrowing, sending the cost of government debt soaring and pushing up the cost of mortgages.
This time round Reeves will be asking the same markets to fund her plans to borrow up to £30 billion that will pay for Labour’s “mission” to rebuild Britain’s infrastructure.
If she succeeds in reassuring the markets that her plans are sensible most of us won’t notice. If she gets it wrong the political and economic consequences could be severe.
So what are bonds, how do bond markets work and why do they matter so much?
In layman’s terms a bond is an IOU issued by governments when they need to borrow money. They are usually issued for a fixed term that can last between a few months and 50 years. They include an annual interest payment for the duration of the bond and when it expires the government pays the creditor the money back.
In the UK bonds 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”.
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UK government bonds are sold to investors at regular auctions held by the Debt Management Office, a Treasury agency. 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 outstanding bonds, most of which have long terms 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.
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This is the crucial factor for the government on Wednesday. In very simplistic terms a bond yield is the rate of interest received by investors who buy the bonds.
Investors, known as bondholders, lend the government money in exchange for government bonds. The rate of interest that they are prepared to accept to take on risk depends on the confidence they have in the long-term health of the government and the British economy.
If confidence in the British economy is high, investors will accept a low rate of interest because they feel assured they will get a return on their investment. If confidence is low, and the investor feels there is a higher chance that they might not get their money back, they will expect a higher rate of return on their investment, to justify the risk they are taking.
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It means, ultimately, that if investors have a high degree of confidence in the overall state of a nation’s finances a government can borrow more cheaply than if they don’t.
Shorter-dated bonds have lower yields as they are less risky to hold than longer dated assets, which are a bet on the future.
The problem for the government at the moment is that it needs to issue new bonds every year to replace those that have reached maturity and to fund additional debt. This means that small increases in yields can significantly push up the cost of borrowing.
UK bond yields have been creeping higher in the run-up to Labour’s budget, 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 they think that the levels of borrowing are sensible and will boost the UK’s growth potential then ultimately the cost of that borrowing may not go up much.
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Conversely if they think the plans are unsustainable then yields will rise significantly to factor in the risk of the new debt.
Bondholders will also have to judge whether Labour’s policy choices will have an impact on inflation, as higher price growth will mean fewer interest rate cuts, a factor that could also keep yields high.
Part of the reason the chancellor chose to announce the changes to her debt rule before the budget was to test the reaction of the markets. However, they have yet to see the detail of the plans and it is the detail which will ultimately determine how the markets will react.