People have been asking me to write a glossary entry on bonds. This is my draft. Comments are welcome.
Background
There is much confusion amongst many people about what the financial instruments that are called bonds might be. This glossary entry seeks to explain some of the issues, without entering into excessive depth.
Bonds
A bond is a promise to pay. The value of the bond represents a sum of money, called the principal, that is entrusted by a person (the bondholder) to an organisation (the bond issuer) for a fixed period of time in return for a predetermined rate of interest, usually called the coupon rate. During the life of the bond, the holder receives this fixed rate of return, usually paid once or twice a year. At the end of the agreed term, or at maturity, as it is called, the principal is repaid in full.
That describes the simple version of the bond. However, bonds come in many forms, and their economic meaning depends entirely on who issues them and why.
Who issues bonds – and why it matters
When a government or a large company issues a bond, it is normally quoted on a financial market. This means it can be bought and sold after issue, and its current market price will vary depending on the supply and demand for the bond amongst savers seeking to own it.
In contrast, when a bank or building society offers what it calls a “bond,” it is not a bond in this sense at all. It is simply a fixed-term deposit, or a savings account with a fixed interest rate and a fixed term. It cannot be traded. It is not quoted on any market. It is a savings product dressed up in grander financial language.
That distinction matters because people often assume that all “bonds” are alike. They are not. A tradable bond is a financial asset with a fluctuating market value. A bank “bond” is just money on deposit.
The basic structure
In its purest form, a bond promises two things:
- To pay a fixed rate of interest, the coupon, over the bond's lifetime.
- To repay the original principal at maturity.
A bond issued at £100 with a 4% coupon will pay £4 a year, every year, until maturity, when the £100 is repaid. The government or company that issued it must meet those obligations, come what may.
Index-linked bonds
That said, not all bonds have fixed returns. Some are index-linked, meaning that either the interest payments, the principal, or both, are adjusted in line with inflation.
In the UK, index-linked government bonds, or “linkers” as they are often called, are adjusted by reference to the Retail Prices Index (RPI) or, more recently, the Consumer Prices Index (CPI). The purpose is to protect investors from inflation by maintaining the real value of their investment.
If inflation rises by 5%, both the interest payment and the value of the bond increase by 5%. This gives holders security, but it also means that when inflation spikes, the government's recorded cost of so-called “debt interest” surges, even though little new cash has actually left the Treasury. What has changed is the future obligation to repay the bond on maturity, which might now be more expensive.
This point is routinely misunderstood. When inflation was high in 2022 and 2023, the government's reported “borrowing costs” appeared to explode. In reality, most of that was the mechanical consequence of indexation on existing bonds, and not a rise in new interest payments.
The market price and yield
The coupon on a quoted bond, say, £4 on a £100 bond, never changes. But the market price of the bond can.
If investors come to expect higher interest rates in the economy as a whole, new bonds will be issued with higher coupons. The old 4% bond then looks less attractive, so its market price falls. A new buyer might only be willing to pay £80 for it. That means the £4 coupon now represents, in simplistic terms (ignoring the time to maturity), a yield of 5% (£4/£80).
If interest rates fall, the opposite happens. The fixed £4 payment looks generous, so buyers are willing to pay more, perhaps £120. The yield therefore falls to 3.33% (£4/£120), again calculated simplistically, which is sufficient for these purposes.
This simple demonstration of changes in value relating to expected interest yield demonstrates the inverse relationship between price and yield. When bond prices go down, yields go up, and vice versa. The key point is that the government's cost does not change. It is still paying the same £4 coupon. What moves is the market's valuation of existing bonds.
To be clear about this, the “interest rate on government debt” reported in the press is not usually the rate the government is paying. It is the market's yield on bonds already in circulation. That yield is a snapshot of what buyers and sellers think those fixed future payments are worth at that moment.
The function of bonds in the modern monetary system
This leads to the biggest misunderstanding of all: that governments issue bonds to fund their spending.
They do not. In a country with its own currency that is widely accepted, and in which its debt is denominated, and with its own central bank, as the UK has, all government spending is funded by the creation of new money by that central bank, which in the UK is the Bank of England. The government instructs its bank to make payments; the bank credits the relevant private-sector accounts, and new money is created in the process. The government's overdraft with the Bank of England is increased as a result.
Taxes then remove most of that money from circulation in the economy by reclaiming it for the government that spent it in the first place. Bonds are then issued to provide a safe home, or a savings account by any other name, for whatever remains in the economy after tax has been paid out of the money the government created. What should be clear, then, is that the government issues bonds solely to mop up the excess money supply it has created and left in the economy after taxes have been paid. This process does not fund its spending: it does instead balance its money creation process, although whether that is technically necessary is another issue altogether, not considered here.
In that case, government bonds are nothing more than savings accounts at the Bank of England, held by pension funds, banks, insurance companies, and other financial institutions, inclduing foreign governments and banks who want a convenient way to hold sterling. They pay interest, they are safe, and they can be traded through the financial markets, all of which show what they are really for: which is to manage liquidity (or safe cash availability) in the banking and financial services system by providing the financial sector with risk-free savings accounts in which they can deposit their excess funds, which were created in the first instance by the government.
To call them “borrowing” is, therefore, misleading. The government does not need to borrow the money it itself creates. It simply offers the private sector an interest-bearing place to store that money safely.
The political and economic confusion
Because bonds are called “government debt,” it is easy to assume they represent a burden on future generations. In truth, they represent wealth in the form of savings held by those who own them. Every pound of “debt” is someone else's asset.
If you hold a government bond, you do not fear repayment. You rely on it. Pension funds depend on gilts precisely because they are the safest assets in existence.
When politicians claim the government must “tighten its belt” because of high “borrowing,” what they really mean is that they would prefer to shrink the size of government and so offer fewer bonds. It has nothing to do with the government's actual capacity to spend.
The reality
Bonds are, quite simply, the plumbing of the modern monetary system. They manage savings, stabilise markets, and provide benchmarks for interest rates. They are not borrowing in any meaningful sense.
The government does not need your money before it can spend. It spends first, taxes later, and offers bonds to absorb the difference. Those bonds are savings deposits by another name.
To describe them as debt is to mistake the government's capacity for credit creation for a household budget. And that, as with so much else in economics, is a category error that has done immense political harm.
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[…] are three things to consider. For background, look at my new glossary entry on bonds, and my suggestion in a video this morning that the last thing we need right now is a tax rise on […]
Thank you for an insightful article!
What might be an approriate label for our National Debt which has the quality of presenting a reasonably valid indication of what its functions and purposes actually are?
National Savings
National investment?
All of us must challenge the linguistic distortion that terms like “national debt” create. These terms, and phrases like “maxing out the nation’s credit cards”, are used by the wider political class to manipulate the population into not questioning today’s failing economic ideology. Like the bogus “household budget” argument which collapses after the most rudimentary analysis, “living within our means” is used by politicians as a means of disguising their political choices as some sort of economic inevitability that, if not pursued, will somehow lead to economic Armageddon. Meanwhile, the wealthy just get wealthier!
Which funnily enough is exactly what we call the national bank. I’ve still got two “National Savings” books. One “blue” current account one, opened when I was six years old, with the £2 not being repayable until my seventh birthday. And a grey “Investment Account” one. Can’t wait to see the impact on the national debt when I reclaim the balance!
🙂
Even though neither of us have A level English, that was very helpful.
It immediately answered a question I had, “What’s the difference between bonds and bank savings?”.
It also brought home to me how “Treasury Speak” and neoliberal economic rhetoric is all about the juggling of numbers on ledgers in the future, and not really about real life now, for real people (what Harold Wilson used to call “the pound in your pocket”).
Getting back to A level English, neoliberal economic rhetoric is about “control”. The words (debt, irresponsibility, within our means, profligate, black hole, overspend, taxpayers’ money) and those mythical numbers about servicing the public “debt”, the “cost of borrowing”, all create the atmosphere in which austerity (taking from those who can least afford it to give to those who already have a gross excess), becomes almost a moral virtue.
That’s grossly immoral, evil, dishonest, cowardly and despicable. We are due for another despicable dose of it in November from Ms Reeves, who no doubt will be wearing clothes someone else paid for, sat next to a man in donor-provided designer spectacles.
Bonds have always given me a headache. It is now cured.
I wonder how many Labour MPs have got A level English? Maybe we should write and ask them. Presumably, those without it will immediately resign?
Thanks, and 🙂
Having traded government bonds since 1985 (and taught market traders since 2010) I can say with some confidence that what you write is correct… and a good explanation for the “layperson”.
There are a couple of bits where what you say is, perhaps, slightly unclear so, if I may, I might e-mail you directly with a couple of suggestions.
Thanks
Appreciated.
Quite a few inaccuracies in your post:
1) “When a government or a large company issues a bond, it is normally quoted on a financial market”
Not true – bonds are not normally quoted on a financial market
2) “If inflation rises by 5%, both the interest payment and the value of the bond increase by 5%”
Not true- the value of the the bond could increase / decrease or stay the same depending on many factors such as associated changes in the expected path of interest rates, as well a supply and demand factors will certainly change in response to changes in inflation
3) “When bond prices go down, yields go up, and vice versa. The key point is that the government’s cost does not change”
Changing inflation does change the cost of borrowing for the government – high inflation will mean higher coupons and maturity payments on index-linked bonds and hence higher borrowing costs.
Also, whilst the cost of nominal existing nominal debt will not change, the government is frequently issuing new debt and hence the cost of that does increase when interest rates rise – the government needs to offer more attractive terms – a higher yield – to attract investors.
4) “They are not borrowing in any meaningful sense.”
Bonds are exactly borrowing in every meaningful sense. They are the exact definition of borrowing used in financial markets and economics – one party ‘the borrower’ issues debt to borrow money from a third party ‘the investor’. The borrower then repays the debt with interest set out in the terms of the bond.
This is a debt that has to be repaid, with interest. Simple. Not sure why you’d try and pretend otherwise?
1) Normally made this clear.
2) I had made clear I had simplified the calculation.
3) I think that is clear in what I said, and this is about bonds and not inflation anyway.
4) Oh dear….another fool who cannot tell the difference between a deposit and borrowing and who has not understood the government can never default.
I suggest you stop wasting my time and go and learn about reality.
1) Bonds are not “listed” and don’t trade on exchanges but Brokertec and MTS are surely a “financial markets”
2) Agreed – but I think you are nitpicking. I did send Richard a rephrasing of this but the thrust of his argument is true. EG, if prices rise 5% then a 1% coupon of £1 this year becomes £1.05 next year and the principal amount (which is not repaid until maturity) rises to £105. The point being “interest” the cash actually paid is only up 5 pence – not 5 pounds.
3) Not sure what your point is. Sure, new borrowing as at current rates – but existing bonds have fixed coupons that don’t change. This means that overall debt servicing costs move slowly…. that is the point
4) You miss the whole point Richard is making – government bonds are different from corporate or other private sector bonds. You can think of the whole gilt market as an exercise in interest rate and liquidity management through open market operations.
Thanks.
I strongly suspect I will, be accepting your recommndations.
“The government does not need your money before it can spend. It spends first, taxes later, and offers bonds to absorb the difference.”
Fantasic, Richard.
Bring back the Birmingham Municipal Savings Bank!
for the benefit of Grumpy CIO
This new ground-breaking academic UK paper “The Self-Financing State” proves: gov’t spending is not funded by taxes or borrowing.
Instead:
Spending creates new money ex nihilo in private bank accounts.
Taxes destroy that money upon payment.
Bond issuance is monetary policy operation (managing reserves), not a funding operation.
This isn’t theory; it’s how the UK’s payment system actually works.
A must-read to end the “household budget”
myth.https://www.ucl.ac.uk/bartlett/sites/bartlett/files/the_self-financing_state_an_institutional_analysis_of_government_expenditure_revenue_collection_and_debt_issuance_operations_in_the_united_kingdom.pdf
“all government spending is funded by the creation of new money by that central bank”
I’m getting there but this is the bit that isn’t clear to me. So I get money isn’t dug out of the ground but created by the bank of England and must have got into the economy somehow. Government spends it into the economy. But now there is money circulating in the economy the government can take some back out (of the economy) through taxation. After all it came from the government in the first place. But can those tax receipts not now be re-spent back into the economy (to redistribute from the wealthy to those in need for example). So in other words some government spending may be (but not necessarily all) funded by new money. And some by taxation (though not through necessity).
Thanks for both for your campaigning work and pedagogical work.
No, tax can’t be reused.
All money is debt. So is tax. Money spent into the economy is debt owing by the government. Tax owed back is money due to the government. When the tax is paid the two cancel out. The debt disappears and since all money is debt, so does the money the governmment spent in the first place disappear, and so does the money used to pay tax back. They are a positive and a negative as far as the governemtn is concerned and wehn matched they add up to nothing – there is no debt left. Does that makes sense?
Perhaps make a distinction between the Primary bond market were the bonds are sold to a limited number of financial institutions having reserves CBRA at the BoE. These reserves which earn a little interest (since 2008 GFC) can only be swapped for financial instruments ie. government bonds earning a better return than the interest on the reserves (which is overpaid and needs reform regard https://www.taxresearch.org.uk/Blog/2025/04/11/why-wont-rachel-reeves-save-20-billion-a-year/ blog post) . So the financial institutions will always buy bonds as they are a secure investment and get a better return (??). The Secondary bond market is where these bonds can be then traded with all financial players and the yield and interest can be influenced by the vagaries of the market to a degree not withstanding that the base rate is set by the BoE in the initial auctions in the Primary market.
Ref https://www.taxresearch.org.uk/Blog/2022/06/17/how-are-the-central-bank-reserve-accounts-created/
I think that’s a separate briefing. But I note what you are saying.
Richard,
In my journey to better understand money and why our government chooses to make the choices it does, it seems to me that everyone ignores the effect on democracy (if one accepts that bonds help finance the government).
If this is to be true then the financial markets have control over the government. Logically, democracy is compromised as the financial markets can dictate terms.
This appears to be true only because our government chooses to accept this to be so. Not because of some natural order but purely through choice. MMT shows there is an alternative. Currently, austerity etc is seen as Fait accompli.
I’m not saying the government can ignore the financial system but the simple step of accepting bonds as savings rather than debt has profound implications for society.
Agreed. That’s why I talk about it.
Very useful reference and ties together all the bits I’ve learnt from reading your blog. Many thanks.
One question that isn’t discussed is whether government bonds really do need to be tradeable.