Government Bond Pricing: Yield, Duration, and the Price-Yield Relationship

Government bonds — gilts in the UK, Treasuries in the US, Bunds in Germany — are fixed-income securities issued by governments to fund their borrowing. They pay a fixed coupon periodically and return par value at maturity. They are the bedrock of fixed income markets: the risk-free benchmark against which all other instruments are priced.

The inverse relationship between price and yield

The most fundamental concept in bond markets is that price and yield move in opposite directions. A bond pays fixed cash flows: if those cash flows are discounted at a higher rate (because the market demands more yield), the present value falls. If discounted at a lower rate, the present value rises.

This means that when interest rates rise, existing bond prices fall — and vice versa. Longer-dated bonds are more sensitive to rate changes than shorter-dated bonds, because their cash flows are discounted for longer.

Duration: measuring rate sensitivity

Duration is the primary measure of a bond's sensitivity to interest rate changes. It represents the weighted average time until the bond's cash flows are received, and tells you approximately how much the bond's price will change for a given change in yield. A bond with a duration of ten years will lose approximately ten percent of its value for a one percentage point rise in yield.

Modified duration refines this measure for bonds with fixed coupons. The concept of DV01 — the dollar value of a one basis point change in yield — is the risk measure traders use daily to express, limit, and hedge their rate exposure.

The yield curve

Government bond yields across different maturities form the yield curve. The shape of the curve — whether it slopes upward (normal), is flat, or inverts (short rates higher than long rates) — reflects market expectations of future monetary policy, inflation, and economic growth. The yield curve is the foundation from which all fixed income products are priced.

How bond prices are calculated precisely, how the yield curve is constructed, and how DV01 is used to manage bond book risk are explored in depth in Market Mechanics — the complete plain-English guide to how a bank's markets business works.