FOOL SCHOOL
Bonds And Gilts - Part II

October 12, 2005

In Part I we looked at the main types of bond and how they are taxed. Here, we look at how bonds are valued and yield curves.

There are two ways to describe the value of a bond. The first is its price and the second is its 'yield to redemption', also known as the 'gross redemption yield', or simply 'yield'. For simplicity we're going to look at gilts in the following examples, but the same principles apply to any type of bond.

Imagine a 5-year dated gilt with a coupon of 6% and a market price of £100 per £100 of nominal stock. Currently, its gross redemption yield is 6%. But say investors decide that, in fact, they are happy to accept just 5% as an interest rate over the next five years. They will buy this gilt, pushing the price up until its effective interest rate, or yield, falls to 5%.

The yield falls because investors now have to pay more for their fixed coupon of £6 per annum. What the price moves up to depends on some quite complex calculations (see this article if you're feeling brave!) but the important point to make is this - if the price of the bond goes up, then its yield comes down and vice versa.

It is much more useful to talk about yields rather than prices because, with yields, it is only the date of the gilt that matters. '5% Treasury 2008' and '10% Exchequer 2008' will have different prices, because one gives you £5 per year until 2008 and the other gives you £10 per year until the same date. However, both these bonds will 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. Balancing all this together is what complicates the calculations and is also why the yield is known as the 'yield to redemption' or redemption yield.

Looking in the business section of a newspaper, we often see lots of different gilts. From these we can pick out a 1-year gilt, a 3-year, a 5-year, a 10-year and a 30-year.

Here's what they look liked at the time of writing:

Gilt name	Approx years to redemption	Redemption date	Gross redemption yield (%)
7 1/2% Treasury '06	1	7 Dec 2006	4.20
4% Treasury '09	3	7 Mar 2009	4.20
4 3/4% Treasury '10	5	7 Jun 2010	4.21
4 3/4% Treasury '15	10	7 Sep 2015	4.28
4 1/4% Treasury '36	30	7 Mar 2036	4.25

What we see is that the 1-year gilt has a slighter lower yield than the base rate (currently 4.5%). This indicates that interest rates are expected to fall over the following year. This yield can be thought of as 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.

Now if we move on to the 3-year gilt, we find that again its yield is the same as the 1-year. This reflects the fact that interest rates are expected to remain at the same level for years 1 to 3. Looking further ahead, we can see that interest rates are expected to be higher in 10 years' time, but only by a very small amount.

Incidentially, the rate for the 30-year gilt is sometimes referred to as the 'long bond yield'. However, the government recently launched a gilt with an even longer life of 50 years!

Yield curves

One way of getting a handle on how these rates change over the different time periods is to construct a graph known as a 'yield curve'. What you do is plot the number of years 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, you've got a yield curve. (This page on Bloomberg's web site has the current yield curve if you want to cheat!)

There are different names for different shapes of curves. Calling something normal is a dangerous game but there is what's known as a 'normal yield curve'. The reason it is considered normal is that longer-dated gilts are higher risk than shorter ones, as movements in interest rate expectations have a greater effect on their price. Therefore, the theory goes, all things being equal, investors should expect a slightly higher interest rate for longer-dated gilts. So, 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, far into the future, the market tends to expect them to stay the same.

Sometimes you can get 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 yield curves are relatively rare. They can indicate that the market is expecting a long period of low inflation. At the moment however, we have something in middle (i.e. neither a 'normal' nor 'inverted' yield curve) as the difference in redemption yields between short and long-dated bonds is very small indeed.

But why do we need to know about all this I hear you cry. The reason is that all these figures give us an idea of what to expect from our own investments and borrowings over various time scales. As an alternative to any investment, we can currently get a cast-iron return (or as near as makes no difference), before inflation, of 4.3% over 10 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 depends on how much we think our investment strategy is riskier than gilts.

Things like shares are effectively like undated securities, because they have no redemption date. For this reason, their value is often calculated by making reference to the long bond yield. Precisely how this reference is made is matter of some debate, but it's one of the reasons why the long bond yield is such an important figure to know about.

The other thing that these yields tells us is what to expect when we're borrowing money. If we want to borrow then, since we're a higher risk than the Government, we will have to pay more in interest than it 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. When these gilt yields rise or fall, you'll often see that fixed-rate mortgages offers often follow suit.

A similar principle applies to corporate debt. Because companies are higher risk than the Government, the rates of interest on their bonds will be higher than gilts, too. The difference between gilt yields and the yield on a corporate bond can be referred to as the 'yield spread'. This is usually expressed in basis points, a basis point representing one one-hundredth of a percentage point. So a yield spread of 200 basis points means the bond's rate of interest is 2 percentage points higher than the equivalent gilt. Investment grade bonds will have a much lower yield spread than junk bonds.

Yield spreads for individual bonds can increase or decrease, depending on the market's perception of how secure the company is. If it is thought that it may have trouble repaying its debts, then the yield on a company's bonds will increase. If you recall, when the yield of a bond increases, then its price falls.

In the final part of this guide, we'll look at credit ratings, how you can invest in bonds and finally, whether you should invest in bonds at all.

> Part I | Part III