Government Bonds

Overview
A government bond is, in effect, a loan given to a government; as compensation for lending the money, the investor is paid a fixed rate of interest (the interest in this case being called the coupon) at regular intervals and gets back the original amount that had been lent (the amount in question being known as the face value) when the bond reaches maturity. 

In the UK, such government bonds are called gilts, a name derived from the fact that the certificates initially had gilt edges.

Examples
The three government bond markets that are most frequently referred to all over the world are those of the UK, the United States and Germany, and they are generally regarded as the best representations of a "risk-free rate" since governments in developed markets are seen as highly unlikely to fail in meeting their obligations with respect to domestic currency debt.

Price and yield
As a bond's price rises, its yield falls because the fixed coupon makes up a smaller share of the higher price; conversely, when the price falls, the same fixed coupon represents a larger share of the lower price, and the yield rises.

To make this clearer, let's consider an example. Suppose that a government launches a 10-year bond with a face value of £100 and a 3% coupon, which entitles it to pay £3 each year. If interest rates rise, a newly issued bond might have a 4% coupon and pay £4 each year on the same £100 face value. 

Consequently, people would not be willing to buy the older 3% bond at its original price of £100 when a newly issued bond offers a higher return for the same amount of money, and so the price of the older bond has to fall until the fixed payment of £3 is equivalent to a 4% return. 

Approximately, its price would have to drop to about £75 so the £3 coupon gives a return close to 4%. This is the reason why rising interest rates cause the prices of existing bonds with lower coupons to fall, and it is the reason why almost every article about the bond market refers to such a situation as the bonds 'selling off' when central banks raise interest rates.

The yield curve

The yield curve indicates the yields of bonds with various maturities that are issued by the same company; in the case of a "normal" curve, that is, one with an upward slope, the bonds with longer maturities offer a higher yield than those with shorter maturities since investors need extra compensation for tying up their money for a longer period.

An inverted curve, this being the case when the rates on short-term bonds are higher than those on long-term bonds, has historically been one of the most closely watched signs of a recession; it generally indicates that the markets expect future cuts in interest rates due to an anticipated slowdown in the economy, which in turn will cause the central bank to ease its policy.

Risks

Because government bonds involve interest rate risk, specifically, since their price drops when interest rates go up, they also involve inflation risk, as a fixed coupon will have lower real value if inflation is high; they usually have a very low degree of credit risk since defaults are rare among developed market governments which borrow in their own currency, even though this does not mean that they are free from risk in all respects.

The 2022 crisis in the UK gilt market is a clear example of this phenomenon; it was caused by the government's mini budget and worsened because pension funds were required to sell their holdings under their liability-driven investment (LDI) strategies.

The prices of gilts changed dramatically over a short time, even though there had always been no real doubt about the UK government's ability to repay its debt. This instance reminds us that market mechanics and the need to sell can drive price swings as much as concerns about creditworthiness.