VALUE INVESTING
A Gilt-Edged Income

By Stephen Bland (TMFPyad)
August 22, 2003

I'm taking a look at gilt portfolios this week. It hasn't got much to do with value investing, but I thought it may be of interest to income investors as an alternative or addition to my equity High Yield Portfolio (HYP)idea. I don't propose for space reasons going into the nature of gilts and will assume for this purpose that readers have a basic understanding of this market. (For an introduction to gilts, see these articles from the Fool School: part 1 & part 2)

In the UK, gilts represent the lowest level of risk that exists to the investor from the viewpoint of default. No other investment, whether in corporate loan stocks, bank deposits, annuities, shares, property or anything else is as secure as gilts, in respect of both capital (with dated stocks held to redemption) and interest.

There are currently 44 gilts quoted of which six are undated and ten are index linked. Redemption dates for dated stocks range from Treasury 10%, repayable 8 September 2003, to Treasury 4.25%, to be redeemed on 7 March 2036. Depending on their need for finance, the government periodically issues new stocks.

The security of gilt income makes them a highly attractive option for income investors who do not wish to take any risks at all with their money. They also suit those who wish to mix a risk income, perhaps from an HYP or property, with a secure element to give a hybrid overall lower-risk income. However, and there is always a however, with level gilts there can be no protection against inflation. Once bought, the income is fixed until redemption. Moreover, most level gilts are trading above par of 100 because they were issued in earlier times of higher interest rates. This means that on redemption a capital loss will be incurred, to offset the higher running yield.

Ideally then, a gilt investor should go purely for index-linked issues. Their combination of income and capital is as secure as exists in the known universe. They also have protection against inflation. It is hard to imagine a more perfect investment for an income seeker. However, and there is always a however, the trade off is that the initial income yield is much lower at about 2% against something around 4.5% on levels.

So the first question that must be answered is how much income the investor needs from their capital. If a 2% yield is sufficient to provide this, then it makes sense to go purely for index-linked stocks, because of the inflationary protection of both income and capital. An important point for someone in their sixties who may live for quite some time. But not that many income seekers I suspect will be able to manage on 2% and a lot more will require the 4.5% level yield even though it cannot rise. You could of course split your funds into both, with a midway yield and some inflationary protection.

What if an investor goes fully into level gilts because they need to maximise income and then inflation rises substantially so that their level income starts to look decidedly poor? To protect against this eventuality, don't put all the funds into one long-dated gilt but buy a portfolio of stocks with a range of gradually increasing redemption dates. In this way, you relinquish the protection of a fixed income for a very long time on the whole fund. In return, you have the option of redeeming part of your fund for reinvestment at several occasions along the way. The idea is you can then reinvest the redeemed issues in your portfolio into the gilts available then, so as to take advantage of the prevailing interest rates at the time. If rates have risen, you win. But if they have fallen, you lose against one single long-dated gilt bought at the outset. But this approach does deliver some flexibility.

The problem at present with doing this is that our very low current interest rate means so few gilts are trading below par. I could find only three, dated 2009, 2032 and 2036, which means to build the kind of portfolio to which I refer would require purchasing many above par issues. Although you receive a higher running yield, there will be an automatic capital loss on redemption. I suspect it will disturb many investors to buy above par gilts, goes against the grain somehow, but there is little choice at present if a staggered date portfolio is to be constructed from level issues. Note that under par issues often carry a lower interest rate than over par stocks of the same redemption year, to reflect the higher demand for the lower par investments.

Are undateds worth buying? The only way to retrieve your capital with these is by selling in the market. The problem is that the price fluctuates with interest rates so you can never know in advance how much you would receive if you have to sell. If interest rates fall you will win and vice versa. The yield is only marginally higher than the longest dated issues, ranging between 4.6 – 5.0%, so you do not receive much compensation for the lack of redemption date. I conclude that undateds are not going to be too attractive for income seekers, even as only part of a portfolio.

For level gilts, it is not a good time to be investing if you object to paying over par and wish to build a portfolio of variously dated stocks. There is far too little choice. The prevailing situation if you insist on buying only under par indicates to me that it might be better to stick all your gilt money into the earliest under par stock, Treasury 4% 2009, and review the situation after redemption in that year. You will have to take a bit of a hit on income though, its yield is only about 4%.

For those willing to accept the much lower yield of index-linked stocks, then these will always possess attractions. I see them as highly desirable. The concept of buying over par with its consequential loss does not arise because there is no par value, just the inflation adjusted capital value.

Finally, on the tax treatment, gilt income is interest income and therefore is taxed accordingly at the marginal rate. Capital gains, either in the market or on the redemption of stocks bought below par, are not taxable.