You will recall that:
- Level 1 was getting to the sound foundation of no debt and paying off your mortgage
- Level 2 was setting up an 'Easy Access' bank accounts (both current/checking accounts and deposit/savings accounts)
- Level 3 was all about fixed-rate bank accounts or 'savings bonds' as they are called in the UK
- Level 4 was about Exchange Traded Funds
What are government bonds?
Government bonds (known as 'gilts' in the UK) represent loans to the government (or State in the US); the bonds are traded on the stock market. When you buy a government bond you have buy the right to (typically):
- Interest - known as a coupon - paid every half-year or year
- Repayment of the principal - the original nominal loan amount (i.e. not necessarily what was paid for it initially) - at the maturity date (although some government bonds do not have a maturity date and are 'perpetual' (at least until the government chooses to repay the principal - which is unlikely)
- Yield Curve
It is useful to understand the concept of the government bond 'yield curve', which is simply a graph plotting the relationship between bond yields and their maturity dates.
Government bonds are usually divided into three maturity categories:
- shorts (one to seven years)
- mediums (seven to 15 years)
- longs (15 years plus).
As the bonds are traded daily, the shape of the yield curve changes in line with current prices. As government bonds have virtually no default risk (unlike corporate bonds), their prices (and thus yields) are determined by supply and demand factors, as well as by expectations of inflation and interest rates. So the shape of the yield curve at any moment is, therefore, a function of supply and demand characteristics at different bond maturities.
- Redemption Yield
The Redemption Yield is the return implicit in the current market price of the bond, assuming that it is held to its redemption and that all interest payments are reinvested back into the bond. It also includes the capital gain, or loss, from holding the gilt until maturity, depending on whether you purchased the gilt at a price below, or above, par (the 'face value' of the bond and the amount that you will get back at redemption).
The Redemption Yield is the standard measure used in bond markets for comparing rates of return on investments with the same maturity.
For the UK, I can offer the following suggestions:
- how much coupon (interest) you will receive
- how much you will get back at maturity
The Rest of the Pyramid
While you are getting Level 4 of the Income Pyramid sorted out, you will have time to make yourself familiar with the higher levels to come:
- Level 6 is about assembling a portfolio of high-yield dividend shares
- Level 7 targets corporate bonds
I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.