FOOL SCHOOL
Gilts - Part 2

January 22, 2003

Following on from this piece, here we 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. The interest rate is not 6 divided by £100, but 6 divided by a higher number. The precise calculations are quite complicated but 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 2008" and "10% Exch 2008" will have different prices, because one gives you £5 per year until 2008 and the other gives you £10 per year until 2008. However, they will both have the same redemption yield.

Incidentally, the reason why the yield is complicated to calculate is that both these gilts will give back £100 in 2008 (on top of their respective coupons). 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 a 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 that confuse the issue. The ones called "Conv" are a bit funny too. Having weeded these out, we can pick a one-year gilt, a 3-year gilt, a 5-year, a 10-year and a 30-year.

Here's what they looked like on Bloomberg's website on January 17, 2003. 

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

      1            7 Dec 03       3.740      
      3            7 Dec 05       3.985      
      5            7 Dec 07       4.209  
     10            7 Mar 12       4.423     
     30            7 Jun 32       4.475 

What we see is that the 1-year gilt had a yield slightly lower than the base rate at this date (which was 4.0% on 17 Jan 2003). This indicates that interest rates were expected to fall over the following 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 basically the same as the base rate of 4.0%. So the market is expecting rates to go back up to their current level from years 1 to 3. Small increases are then expected from 3 to 5 years hence and from 5 to 10 years as well.

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 4.475%. So, the gross redemption yield for a 30-year gilt is 4.475%. 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.

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 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 a minor case of what is known as an "inverted yield curve". This is where the yield falls when looking at longer-dated gilts (i.e. those of 20 and 30 years). Inverted curves are relatively rare. They can indicate that the market is expecting a long period of low inflation.

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 4.4% over 10 years and 4.5% 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, 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 that has the smallest area under it. It's only a rough approximation but it's a good place to start.

> Gilts & Corporate Bonds discussion board | Gilts - Part 1