Personal Finance

[ November 16, 1999 ]

Grappling With Gilts -- Part One

By James Carlisle (TMFJimmyC)

This week I am going to take a look at gilts. In particular, we will be looking at what they can tell us about the current investing environment. It is perhaps not the most gripping of subjects (especially since we won't get to the best bit until Thursday) but, before we all fall asleep, I'll say that understanding them is one of the most fundamental things in finance generally. So, if you understand them already then go ahead and fall asleep. However, if you don't, grab a cup of coffee and do your best.

Conventional Gilts

Put simply, gilts can be thought of as loans made by investors to the British Government. What the Government does is sell investors "bonds" (known as gilts) which represent a promise to pay Interest over the duration (often called "term") of the loan and to repay the capital amount of the loan at the end (this last bit is often described as "redemption"). Interest is generally paid half-yearly.

So, for instance, if the Government wanted to raise £1 billion, to be repaid in 10 years time, with a fixed interest rate of 6% per annum (often called the "coupon") then it might "issue" some gilts. In these circumstances, they might be called something like "6% Treasury 2009". The 6% indicates the annual coupon and the 2009 indicates when the Government will pay the money back (that is, redeem the bonds). The word in the middle represents nothing much. It can be "Treasury" or "Exchequer" or a few other things. There might be some hidden reason behind the different names. But no one seems to know what it is. Maybe it's just done on the whim of the Bank of England officials. If any one knows a better reason, we'd love to hear from you on the personal finance message board.

Generally gilts are sold in chunks of £100. You will therefore see prices for them quoted in newspapers at around this price. It's interesting to note that the gilts with prices below £100 generally have coupons below current base interest rates (5.5%), and those with coupons above base rates are generally priced at over £100. In fact, on the whole, the higher the coupon, the higher the price. The reason for this is that gilts are generally issued with a fixed coupon. A gilt with a coupon of 6% will pay a total of £6 per year, whatever. If interest rates rise, then the value of the gilt must fall to reflect this. We will go into this in more detail on Thursday.

Other Types

There are a couple of other types of gilt, which I will only mention in passing for the moment, because otherwise they'll just confuse things. These are undated gilts and index-linked gilts. Undated gilts, as the name implies, are designed to carry on paying their coupon forever, without ever being redeemed. However, you have to be a bit careful with them, since they are not actually as undated as they sound and some may, in fact, get redeemed in due course. They tend to have low coupons (of around 3% pa) and therefore their price tends to be quite a lot lower than £100. Index-linked gilts pay a coupon which rises with inflation. In fact, it's not quite as good as this, because they lag inflation by eight months. However, if you're looking for low risk, it probably doesn't get much lower.

So, like we might take out a mortgage, the Government might issue some gilts. However, there are one or two major differences. Unlike our mortgages, the gilts aren't all with one lender. Since the gilts can be bought and sold, the Government is being lent money by all those people and companies that own gilts at any one time. In other words, when people buy and sell gilts, what they are doing is buying and selling little (or sometimes quite big) slices of Government debt. It is as simple (and as complicated) as that.

Risk Free? Sort Of

Another major difference between the Government issuing gilts and us having a mortgage is that, when they borrow money, unlike us with our motgages, they don't give us a legal charge over the Houses of Parliament (or anything else). However, since the Government has never actually defaulted on a loan, the view is that you don't really need security and that's probably fair enough. For this reason, gilts are often described as "risk-free" assets.

Unfortunately, (apart from index-linked gilts) this doesn't really provide the full picture. The Government makes the polices which, amongst other things, determine the level of interest rates and, in particular, inflation. These have a major effect on the value of gilts. The Government is therefore in the privileged position of being able to influence the real (that is, post-inflation) value of its debt. This sounds handy, but it has a problem over the long term. If there is too much inflation, then investors will become wary and expect a higher interest rate on their gilts in the future. Long term, then, it is in the country's interest for the Government to maintain a disciplined approach to inflation. Thankfully, there is a lot of evidence that recent Governments have taken this point on board. This has a lot to do with the strong price rises in the gilt market in recent years and this strength has also passed through to shares and the property market.

Amendment To Previous Article

There was an error in my article of last Tuesday, "Poorly Endowed - Part One". In it, I suggested that an endowment might not have a surrender value after seven years. This was incorrect. Endowments will certainly have a surrender value after seven years. The article has been amended and I apologise if it caused any confusion.

Questions and comments on this article should be directed to the Personal Finance message board.