Government Bonds: Gilts: Gilt-Edged Securities

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Gilt (UK) is short for gilt-edged (gilded-edge) security or bond.

They are also known as Treasury Stocks.

Gilts are bonds or loan stock issued and guaranteed by the Government of the United Kingdom.

There are:

• Shorts
  Short-term gilts redeemable within five years.
• Mediums
  Medium-term gilts with five to fifteen years to redemption date.
• Longs
  Not to be redeemed within fifteen years.
• Indexed-linked
  Both interest and capital repayment are linked to the RPI (Retail Prices Index).
• Undated
  No fixed redemption date

They are ranked as safer than equities because it is thought unlikely that the Government could go out of business.

But there is always an element of risk.

The UK Government guarantees that it will repay the debt, associated with the gilt, in full, by a certain date, at the gilt face value.

This is known as "at par".

Until the gilt is redeemed (bought back) the UK Government will pay a fixed rate of interest on a regular basis - usually every 6 months.

The interest rate is expressed as a percentage of the face value.

This is called "the coupon".

So, apart from the Government going bust, what is the risk?

The risk is to be found in the secondary market.

The secondary market is the Stock Exchange. This is where gilts are traded, after they have been issued.

In the Stock Market investors are prepared to purchase the gilts, not at par, but at a variable rate according to the prevailing interest rate.

They are also prepared to purchase the gilts, not at the current interest rate, but at an expected interest rate in the future.

The risk element is linked to the date at which you have to sell.

If you have to sell before the redemption date, then you run the risk you will not receive back what you paid for the gilt.

Why issue gilts?

When the Government issues a new gilt to the market they are trying to raise funds.

The first purchaser is therefore lending money to the Government.

Once bought they can be traded on the secondary market, as outlined above.

When looking at the financial newspapers you will note names like:

• Treasury
• Exchequer
• Consol

From 2005-2006 all new gilts are named Treasury Gilts.

All gilts act essentially the same way.

It is the information that comes after the name of the gilt that differentiates each from the another.

The information is in two parts:

• Coupon
  The nominal interest rate
• Maturity year
  Date of redemption

Gilts are classified by their dates of redemption: the date on which the Government has promised to repay the debt (the gilt's face value).

Scan the financial papers again to see the redemption yield column for gilts.

This is a calculation of the total return that can be expected at that point in time, if it is held until maturity (redemption date).

The calculation includes both the interest yield, and the element of gain or loss, associated with the gilt when it is finally repaid at face value.

You will find that the redemption yields are different for each gilt.

Why do redemption yields differ??

The reason is tax.

When yields are quoted 'after tax', they look much different.

The lower the coupon rate on a gilt, the greater the percentage of the total return comes as capital gain.

This is a major consideration for tax-payers, especially higher rate tax payers, as gilts come free of capital gains tax. So the lower the coupon, the less tax will be paid as tax.

There is one other consideration: the maturity year.

Interest rates cause the price of longs to swing more than shorts.

Longs are more volatile in relation to interest rates.

So for your investment strategy you must match your view on interest rate changes to the appropriate gilt.

In simple terms:

• When interest rates rise, gilt prices fall.
• When interest rates fall, gilt prices rise.

When do gilt prices fall?

When interest rates rise it is likely nobody will want to buy your gilt, as they can get a better deal elsewhere.

Investors can earn more with a different investment instrument.

The price of your guilt is discounted (the price is lowered by the market), in order to adjust the price to the yield equivalent to the prevailing interest rate.

Why do gilt prices rise?

In the same way, when interest rates decrease your gilt is more attractive: the yield is adjusted, and the price rises.

An effect of this is that the real return with gilts has not been particularly good over time.

There is risk involved as the real return can be negative.

Gilts can be very attractive if you are a higher-rate tax payer.

Equities are not always the best option. There are times when gilts can give a better return by out-performing the market indexes.

When markets are stagnant and bearish, and yielding mediocre results overall, then, apart from specific equities that give superior returns, gilts are the better option.

Gilts should be considered as a component of any well-balanced portfolio, especially where the after-tax position is considered.

I will return to gilts in a later article to explain Index-linked Gilts and Convertible Gilts, and the techniques for evaluating all types of gilt.