Gilts

The term is an abbreviation of ‘gilt-edged securities’. The suggestion is that of class, distinction and dependability. The implication is that these bonds issued by the British government are safe and reliable. There is some justification for that: the government started borrowing from the City of London in the 16th century, and it has never defaulted on either the interest or the principal repayments of any of its bonds. Although gilts are a form of loan stock not specifically backed by any asset, the country as a whole is assumed to stand behind the issue and therefore default on future gilts is pretty unlikely as well – the risk is reckoned to be effectively zero.

Gilts exist because politicians may think tax revenues are suffering only because the economy is in a brief dip and they want to bridge that short-term deficit, or they dare not court voter disapproval by raising taxes to cover state expenditure. The difference between revenue and expenditure is made up by borrowing – this is the Public Sector Borrowing Requirement or government debt, much discussed by politicians and the financial press. In effect it passes the burden to future generations who pay interest on the paper and eventually redeem it (buy it back at a specified date).

The issues have a fixed rate of interest and a stated redemption date (usually a range of dates to give the government a bit of flexibility) when the Treasury will buy back the paper. The names given to gilts have no significance and are merely to help distinguish one issue from another.

The interest rate set on issue (once again called the ‘coupon’) is deter­mined by both the prevailing interest rates at the time and who the specific issue is aimed at. The vast majority of the gilts on issue are of this type. In addition there are some index-linked gilts and a couple of irre­deemables including the notorious War Loan – people who backed the national effort during the Second World War found the value of their savings eroded to negligible values by inflation. This is still on issue and the financial crash of 2008 stopped it being a joke as it gained new life in the low-interest environment.

There is a long list of gilts being traded with various dates of redemp­tion. For common use these are grouped under the label of ‘shorts’ for ones with lives of under five years, ‘medium-dated’ with between five and 15 years to go, and ‘longs’ with over 15 years to redemption. The government has also been issuing ultra-long gilts with up to 50 years to redemption. On the whole these are probably more aimed at and suit­able for investors such as pension funds and insurance companies, which need assets to match the longer lives of pensioners.

In newspaper tables there are sometimes two columns under ‘yield’. One is the so-called ‘running yield’, which is the return you would get at that quoted price, and the other is the ‘redemption yield’, which calcu­lates not just the stream of interest payments but also the value of hold­ing them to redemption and getting them repaid – always at £100 par (the face value of a security). If the current price of the gilt is below par the redemption yield is higher than the running yield, but if the price is above par (which generally suggests it is a high-interest stock) one will lose some value on redemption so the return is lower.

Since the return is fixed at issue, when the price of a bond like gilts goes up, the yield (the amount you receive as a percentage of the actual cash invested) goes down. Let us assume you buy a gilt with a nominal face value of 100p (yes that is £1, but the stock market generally prefers to think in pennies), and with an interest rate of 10 per cent set at issue. If the current price of that specific gilt is 120p, you would get a yield of 8.3 per cent (10p as a percentage of the 120p paid). If the price of that issue then tumbles and you buy at 80p you could get a yield of 12.5 per cent (10p as a percentage of 80p).

There are other public bonds of higher risk than UK gilts. These include bonds issued by local authorities and overseas governments. Calculations used to be straightforward when many decades of stability suggested neither local authorities nor foreign government would become insolvent. The 2008 crash and subsequent financial turbulence in many countries woke up the market to the fact nothing can be taken for granted – not even sovereign debts are always safe, especially from countries with large deficits. It has indeed happened before as any collector of unredeemed bonds will testify. Chinese governments, Tsarist Russia, US states, Latin American enterprises and so on have all issued beautifully engraved elaborate bonds that are now used to make lampshades or framed deco­rations for the lavatory, because they were never redeemed. On overseas bonds there is also the added uncertainty from currency movements.

As always, and this is an important rule to remember for all invest­ments, the higher the risk the higher the return to compensate for it. So if something looks to be returning fabulously high dividends it must be because it is – or it is seen to be – a fabulously high-risk investment.

In the case of public bonds the higher risk than UK gilts means local authority and foreign government bonds provide a higher yield, varying with the confidence in the countries’ financial stability, and corporate bonds sometimes slightly higher still, depending on the issuer and guar­antor (often a big bank). The differences are generally marginal for the major, safe issuers, seldom much more than 0.3 per cent.

Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.