FOOL SCHOOL
Grappling With Gilts - Part I
October 29, 2001
Trawling through our archives, it occured to us just how much material that we have written over the last four years is now gathering cyberdust. Much of it deals with the basics of personal finance and investing but, being tucked away in some murky corner of our website, few people will probably find these pieces. Hence this new series of articles - Fool School. This will run every Monday, Wednesday and Friday. To kick off proceedings we have a two-article series on the mysterious beasts that are Gilts.
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 2011". The 6% indicates the annual coupon and the 2011 indicates when the Government will pay the money back which is known as redeeming 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.
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, 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.
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 slices of Government debt. It is as simple 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. 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.
> Part II - Yield
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