Government bond is an official document promising that a government or company will pay back money that it has borrowed, often with interest. (Longman Dictionary of Contemporary English) Interest is called ‘coupon‘.
Below is an explanation on how it works in the financial market with an example of US treasury note with 10 years maturity. It is issued by United States Department of the Treasury and called just ‘treasury’ in newspapers or magazines.
The US sells a treasury note with a face value and a discount value. If you buy a treasury note with a face value of $1000, you have to pay a discount value of $950. After owning 10 years, you will redeem a face value of $1000 and interest.
The treasury collects interest of 3% per year over 10 years, which comes to $30 yearly, and at the end of the 10 years (the maturity) cashes it out for $1000. So, $950 over the course of 10 years becomes $1300.
Treasury notes are sold and bought in the financial market before their maturities. The prices are usually higher than their face values, e.g. $1200. The investors expect that the treasury notes value will become $1300 and buy them for $1200 in the financial market. In this case, the yield of the bond is
(1300 – 1200) / 1200 x 100 = 8.3%.
And the profit of maturity is $100.
When the economy is in a slowdown or downturn, investors avert risk to invest and buy bonds as risk off assets. Bonds become very popular with investors despite its prices going up in a downturn. Consequently, the yield of the bond becomes low. If the market price of the bond is $1299, the yield is
(1300 – 1299) / 1200 x 100 = 0.083%.
And the profit of maturity is only $1.
Thus, when bonds’ prices go up, yields plummet.
Recently, in some countries like Japan, Sweden and some EU countries, interest rates are negative. For example, investors buy the bond of the mutual value of $1300 for $1301. They will realize the loss of $1 on the mutual day. However, bonds are so popular that the bond bought at $1301 would be sold at $1302 and the investor would get the profit of $1.