Personal Finance

[ November 18, 1999 ]

Grappling With Gilts -- Part Two

By James Carlisle (TMFJimmyC)

In Tuesday's article, I tried to explain what gilts are. The reason for this was simply to provide the background to today's piece, which is about what gilts can tell us. For the time being, we aren't going to discuss whether or not we should be buying them: we are simply going to look at what the price of gilts, and more particularly their "yield", can tell us about the current financial climate.

Pricing Gilts

There are two ways to describe the value of a gilt. The first is its price and the second is its "yield to redemption" also known as its gross redemption yield, or simply yield.

Imagine a 5-year dated gilt with a coupon of 6% and a price of £100. Currently the yield is 6%. However, if investors decide that, in fact, they are happy only to accept 5% as an interest rate over the next 5 years, then they will buy the gilt, thereby pushing the price up until its effective interest rate, or yield has fallen to only 5%. The yield falls because investors now have to pay more for their fixed coupon of £6 pa. Thus the interest rate is now not 6 divided by £100, but 6 divided by a higher number. The precise calculations are quite complicated but, for our current purposes, the important point to make is this -- if the price goes up, the yield comes down.

It is much more useful to talk about yields than prices because, with yields, it is only the date of the gilt that matters. "5% Treas 2004" and "10% Exch 2004" will have different prices, because one gives you £5 per year until 2004 and the other gives you £10 per year until 2004. However, they will both have the same redemption yield. Incidentally, while I'm here, the reason why the yield is complicated to calculate is that both these gilts will give back £100 in 2004 (on top of their respective coupons). You might think that a 10% coupon would be worth twice as much as a 5% coupon. The reason why it isn't is that it doesn't give you twice the money back in 2004. Both gilts pay back only £100. Balancing this all together is what complicates the calculations and is also why the yield is known as the "yield to redemption" or redemption yield.

Yield Curves

So, looking in the business section of today's newspaper or on the Bloomberg website, we can see lots of different "conventional" gilts. First of all, if you're looking in the paper, forget any that give two dates (for example Treas 12 ½% 2003-05). These have special rules which confuse the issue. The ones called "Conv" are a bit funny too. Having weeded these out, we can pick a one-year gilt (redeeming in 2000), a 3-year gilt, a 5-year, a 10-year and a 30-year.

If you're looking at Bloomberg, they've picked some for us. I've listed a few of these below. I did this yesterday, so the yields may have changed a little since then. Also, I've converted the dates over to the British format. You might notice that the 30-year gilt is in fact only about 29 years, its just that people like to talk of the "30-year gilt yield" and there are only so many around.

  Approx.                  Gross
 Years to   Redemption   Redemption
Redemption     Date       Yield(%)

     1       07/12/00      5.789
     3       07/06/02      6.055
     5       26/11/04      5.836
    10       07/12/09      5.068
    30       07/12/28      4.109

What we see is that the 1-year gilt has a yield slightly higher than current base interest rates (which are 5.5%). This is because interest rates are expected to rise over the year. This yield is therefore a sort of average of the expected interest rates over the next year. Investors are basically lending money to the Government on a 1-year fixed rate loan. The Government is a better credit risk than we are, so the interest rate is lower than we would have to pay. In fact this rate is the lowest sterling interest rate that you'll find (ignoring things like discounted rate mortgages which find other ways of getting the money off you).

Now if we move on to the 3-year gilt, we find that its yield is higher still. Again, this is because the market expects interest rates to keep on rising. However, when we move on to the 5-year gilt, we find that the yield has fallen back to 5.836%. This is because, overall, the market expects interest rates to rise for the next 3 years and then start to fall again. So, by the time we get to 5 years, the yield is lower again. After this, the market expects interest rates to keep on falling, so the redemption yield keeps coming down. By the time we get to 30 years, the effective interest rate that investors require in order to lend the Government money for 30 years is just 4.109%. So, the gross redemption yield for a 30-year gilt is 4.109%. This is also frequently referred to as the "long bond yield".

You can try constructing a graph, if you like. Lots of people do. It's called the "yield curve". What you do is plot the number of years to redemption along the bottom (the x-axis), and the yield up the side (the y-axis). Then you put in a dot for as many gilts as you can be bothered to find, join the dots together and, hey presto, a yield curve. Unfortunately, our software isn't very good at graphs. Otherwise I'd do one for you. If you'd like more detailed instructions, please say so on the personal finance message board and I'll do my best.

There are different names for different shapes of curve. Calling something normal is a dangerous game, but there is a "normal yield curve". The reason that it is considered "normal" is that longer dated gilts are higher risk than shorter ones (movements in interest rate expectations have a greater effect on their price). Therefore, the theory goes (and it's not a bad one) that, all things being equal, investors should expect a slightly higher interest rate for longer dated gilts. Therefore the yield goes up as the date does. As time goes on, it also tends to flatten out. This is because interest rates can't be zero (at least not forever), or go up to infinity. So, long into the future, the market tends to expect them to stay the same.

At the moment we have an "inverted yield curve", almost. An inverted curve has the yield falling as the date goes up (although, again, it flattens out at around 30 years). I say almost inverted because, at the moment, the curve just nips up slightly up to 3 years and then falls.

So, when you next need to impress at a dinner party, try something like "I see the peak of the yield curve has shortened to three years and the inversion is becoming more pronounced". While saying this, you should hold your forearm up in front of your face and wiggle it around to demonstrate the shape of the curve. If you can manage to keep a straight face while you do it, everybody should be well impressed.

What Does All This Mean Then?

All these figures give us an idea of what to expect from our own investments and borrowings over these various time scales. As an alternative to any investment, we can get a cast-iron (almost) return, before inflation, of 5.068% over 10 years and 4.109% over 30 years. So, if we want to invest in anything else, then we will want to make a return of more than this. How much more than this depends on how much we think our investment strategy is riskier than gilts. Things like shares are effectively like undated securities (because there is no redemption). For this reason, their value is often calculated by making reference to the long bond yield. How this reference is made is a matter of some debate. However, it's why the long bond yield is so important.

The other thing that these yields tell us is what to expect for borrowing money. If we want to borrow money then, since we're a higher risk than the Government (even if our house is on the line), we will have to pay more in interest than they will. However, the interest rate that we pay should still be relative to the gilt yield for any given period. For mortgages, because the lender has our house as security for the loan, we only pay about 1 to 2% or so above the gilt yield. So, if you are, say, looking at a 5-year fixed rate mortgage, start by comparing it to the yield on a 5-year gilt. Similarly, you can compare the value of a 2-year fix to the 2-year gilt yield.

For the different products, imagine their own yield curves. You probably want the one that stays lowest for longest. That is the one which has the smallest area under it. This will only be a rough approximation because we haven't factored in the time value of money (that is, that payments actually cost us less the further away they are because the money can be working for us in the meantime). But that, as they say, is another story and it will have to wait for another day.

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