What is a gilt? Conventional & index linked - Share Centre

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What is a gilt?

The differences between conventional and index linked gilts

What are gilts?

When a government needs to borrow money to finance public spending (because there’s a shortfall between tax revenues and spending requirements), it issues bonds – IOUs, essentially. When the term ‘gilt’ is used, it normally refers to bonds issued by the British government.

Some claim that the term ‘gilt’ arose because the original bond certificates used to be edged in gold – thus ‘gilt-edged securities’. However, the UK’s Debt Management Office (DMO), which issues UK gilts, says the name refers to their security as an investment, rather than any historical physical feature.

Gilts are seen as extremely low-risk investments. While the UK government’s finances have had their ups and downs, the country has a very good credit record – the UK government has never technically defaulted on its debt. In other words, it has always paid the interest due on its debt, and it has always repaid the original loan back when the bond matures (i.e. when the IOU is due).

That’s not the same as saying that investors in gilts cannot lose money, as we’ll see in a moment. But if you hold a gilt, you can be very confident that the UK government will meet payments on that debt.

There are two main types of gilt: conventional gilts and index-linked gilts. We’ll look at them in turn.

Conventional gilts: the key features

The most common type of gilt is a conventional gilt. These UK government bonds promise to pay the holder a fixed cash payment (the ‘coupon’) every six months until the ‘maturity’ or ‘redemption’ date – at which point the holder is paid the bond’s face value (the ‘principal’).

The name of a conventional gilt will look something like this: 5% Treasury Gilt 2018.

The ‘5%’ refers to the coupon as a percentage of its face value (or ‘nominal value’) when issued. In other words, this gilt pays out £5 a year, or £2.50 every six months, for each £100 invested at issue. The gilt matures in 2018, on a specific date – on that day, the holder will be paid £100 (plus the final coupon).

When gilts are issued, they might have maturity dates five, ten or 30 years into the future, but both shorter and longer maturities are available – for example, gilts with 55-year maturities have been issued in recent years.

What affects the price of conventional gilts?

When gilts are issued, they are sold at auction, and can then be sold in the open market. So the price
actually paid for the gilt will not always reflect its nominal value.

The actual price will depend on two main factors. Firstly, there’s the coupon on offer. If a gilt is offering a 5% coupon on a face value of £100 at a time when the typical bank account pays 2%, for example, then demand will be high. As a result, the price of the gilt will rise to more than £100, and the gilt yield will fall below 5%.

Then there’s the maturity date. Put simply, when investors expect interest rates to rise (perhaps in response to rising inflation), gilt prices will tend to fall and yields rise. When interest rates are expected to fall, gilt prices will tend to rise and yields fall. The closer the gilt is to its maturity date, the less affected it will be by changes in interest rate expectations.

If you trade a gilt (i.e. buy and sell it before it is redeemed), you could make a capital loss. But if you buy and hold to maturity, you should be able to work out exactly what you’ll get in nominal terms – including the coupons.

For example, say you buy a gilt with a face value of £100 and a coupon of 5%, which matures in one year. You buy it for £103. In a year’s time, you’ll have had £5 of coupon payments, and you’ll be repaid the £100 face value. So you’ve lost £3 on the purchase price, but you’ve made a £2 total return, taking into account the coupon payments.

Of course, this may or may not be an attractive return in ‘real’ terms (after inflation). But you won’t have lost money in nominal terms.

You can find the ‘yield to maturity’ (or redemption yield) – a trickier calculation, which shows your annual return taking account of reinvested coupon payments, their timing, plus the return of capital at the redemption of the bond – on various financial websites.

Index-linked gilts: the key features

Index-linked gilts (often known as ‘linkers’) were first issued in 1981, and differ from conventional gilts in that they offer some protection from inflation. The coupon payment, and the amount you are paid on redemption, is adjusted in line with the level of the retail prices index (RPI), with a lag of either eight or three months, depending on when the linker was issued.

Valuing an index-linked gilt is more complicated than for a conventional gilt because the future coupons and redemption price are uncertain. As a result you need to make assumptions about the future rate of inflation to work out the yield to maturity.

One useful measure is to look at the ‘breakeven inflation rate’. This shows the inflation rate at which an index-linked gilt will deliver the same return as the equivalent conventional gilt. If you expect inflation to be higher than this over the lifetime of the gilt, then the index-linked version should outperform – assuming you are right. If you expect it to be lower, then the conventional should deliver a better return.

Note that, as with conventional gilts, it is possible to lose money on index-linked gilts if you trade them. Also, if the retail prices index falls – if we see deflation – then the coupon on the index-linked gilt will also fall.

Gilts: how do I buy them?

You can invest in individual gilts via your broker. Alternatively, you can buy exchange-traded funds (ETFs) which track the value of conventional or index-linked gilts, or you could invest in a specialist bond fund.