Introduction

Government bonds are a vital financial instrument that help governments raise funds and investors earn returns. Understanding coupon, maturity, and yield is crucial for AQA Economics.

Bonds in Context

A government bond is a debt security issued by the government to borrow money from investors. These bonds promise fixed payments over time and repayment of the principal at maturity.

Investors buy bonds for stable returns, while governments use them to fund expenditure without immediate tax increases.

Coupon

The coupon is the fixed annual interest payment paid to the bondholder, usually expressed as a percentage of the bond’s face (nominal) value.

• For example, a £1,000 bond with a 5% coupon pays £50 annually.

• Coupons are typically paid semi-annually or annually.

• The coupon remains fixed for the life of the bond, but its value to investors changes depending on market interest rates.

Maturity

The maturity of a bond is the date at which the principal (the original amount borrowed) is repaid to the investor.

Key features:

• Bonds may be short-term (less than 5 years), medium-term (5–10 years), or long-term (over 10 years).

• The longer the maturity, the greater the risk of interest rate fluctuations affecting the bond’s market value.

• Investors prefer shorter maturities in uncertain times, while governments often issue long-term bonds to spread repayment obligations.

Yield

The yield measures the effective return an investor receives from a bond, taking into account its coupon payments and the price paid for the bond. Yield is expressed as a percentage.

For example, if a bond with a £50 coupon is trading at £1,000, the yield is 5%. If the bond price falls to £800, the yield rises to 6.25%. This shows why yield is influenced by bond prices.

This formula demonstrates how to calculate the Yield to Maturity (YTM) for a coupon bond, considering price, coupon payments, and time to maturity. Source

Relationship Between Coupon, Maturity and Yield

These three factors interact in determining the attractiveness of bonds:

• Coupon sets the nominal income stream.

• Maturity determines how long the investor must wait for repayment of the principal.

• Yield reflects the actual return, which may be higher or lower than the coupon rate depending on the bond’s current price in the market.

Bonds with longer maturities are generally more sensitive to interest rate changes. If market interest rates rise, existing bonds with lower coupons become less attractive, reducing their price and raising their yield.

The Government Bond Yield Curve illustrates the typical upward slope, indicating that longer-term bonds generally offer higher yields due to increased time and risk factors. Source

Why Yield Matters

Yield provides a standardised measure for comparing bonds of different prices and maturities. Investors focus on yield to:

• Compare government bonds with corporate bonds, equities, or savings accounts.

• Assess risk and expected return.

• Anticipate central bank policy changes, as yields often rise when markets expect higher interest rates.

Government Bonds in Monetary Policy

Government bond yields are closely linked to central bank actions:

• When the Bank of England lowers interest rates, existing bonds with higher coupons become more valuable, pushing their market price up and yield down.

• Conversely, higher base rates cause bond prices to fall and yields to rise.

This interaction ensures bonds play a critical role in the transmission mechanism of monetary policy, influencing borrowing costs and investment decisions across the economy.

Key Takeaways for AQA

• Know the terms coupon and maturity in relation to government bonds.

• Be able to calculate yield using the provided formula.

• Understand how coupon, maturity, and yield interact in financial markets.

• Recognise how these factors link to broader macroeconomic policy and investor decisions.