What are Gilts?

Gilts are the crème de la crème of low risk investments. Backed by the British government, no other investment offers a more watertight guarantee. However unlikely, there is always the possibility that a bank, building society, guaranteed bond or structured product provider will go bust. The chances of the government doing the same are infinitesimally small.

Gilts are, very simply, units of debt issued by the government. When buying them, you are effectively lending money to the government, which promises to pay back the amount in full (known as the principal) at a set date, along with interest (known as the coupon).

Gilts are issued at par (100p), but are then traded on the open market. This means you can sell the gilt before its redemption date, in which case you might not recoup your initial investment. But it also means that you can buy gilts below par and hold them till redemption to make a profit, or, of course, buy them above par and actually make a capital loss.

Gilt prices rise when the Bank of England cuts the base interest rate, and fall when the base rate goes up. So gilt yields rise and fall with interest rates. This is one of the great attractions of conventional gilts – you can lock into a high yields that will be maintained no matter how far rates subsequently fall. Gilt prices are also affected by the market’s perception of future interest rates, and this is reflected in the yield curve (see below). The longer a gilt has to maturity, the more sensitive it is to changes in interest rates – something known as duration risk.

With rising commodity prices putting upward pressure on inflation, you might think that committing capital to a fixed-income product would be crazy. But, for capital-rich investors wanting both water-tight security and predictability, this isn’t necessarily the case. This is especially so when considering gilts, for two reasons. Gilt yields have become more attractive, while spreads between gilt and corporate bond yields are much lower than they were five years ago. Consequently, the highest level of capital protection can be bought more cheaply. This is particularly pertinent because the US sub-prime bond market is facing difficulties, and the consequences may be contagious.

If you aren’t capital rich, or don’t have a specific investment target (ie, school or university fees), building society savings accounts may be a suitable vehicle. However, for investors sitting on capital in excess of, say, £250,000, there is inevitably a ‘parking problem’. Remember, here, that building society/bank deposits over £35,000 are not protected by the UK deposit compensation scheme, so you would need to distribute your savings among a number of institutions. As for the stock market, this may offer the prospect of better returns over the medium term, but equities carry far higher risks.

Gilt types

A conventional ‘gilt-edged security’ is the simplest and oldest form of government stock. The bond pays out half the annual coupon every six months until the maturity date, when the final coupon payment and principal (the initial investment) are paid to the holder in full.

Investors with strong opinions on inflationary trends might prefer an ‘index-linked gilt’. These are particularly suitable for investors who want a fixed return that is inflation-proof. This protection is achieved by adjusting the value of both the coupon payments and principal for inflation. The adjustment factor, which is lagged, is calculated by reference to the original nominal value of the holding and the change in the Retail Price Index (RPI) since the time of issue. The coupon is paid on the uplifted capital value.

Index-linked gilts should be avoided when deflation is a possibility, though, because the adjustment factor can work both ways (ie, deflation would reduce interest payments). For high-rate tax payers, there may be some advantage in holding index-linked rather than conventional stock, because tax is payable only on the relatively low coupon payment, based on nominal value (they are exempt from income tax on the inflation-protection element of the coupon, as well as capital gains tax. However, the tax advantage may not be substantial enough to warrant foregoing a higher coupon paid by a conventional gilt.

Index-linked yields invariably look much lower than those of conventional gilts. This is because index-linked yields are the values received in addition to inflation, whereas inflation is included for conventional gilts. Thus, a ‘real’ yield on index-linked gilts of 2 per cent is equivalent to a 5 per cent yield on a conventional gilt, when inflation is 3 per cent.

The third type of gilt is called a Strip – effectively a zero-coupon bond that is sold at a discount to the nominal value. Strips are separately traded non-interest bearing bonds with all the return derived from the capital appreciation that results as the bond reaches maturity. With a Strip, you might think that you can escape the eye of the Inland Revenue (IR), but all gains from gilt Strips are effectively taxed as income on an annual basis. Holders are deemed to have “bed and breakfasted” the Strip if they hold it from one year to the next, and any resulting gains (or losses) are taxed as income. Effectively, the IR deems that the holder sells the stock at the closing price on 5 April, and repurchases the same security on 6 April.

With this in mind, Strips are only really suitable for those investors who are both capital-rich and low-rate tax payers, and who do not need any ongoing income payments. A likely candidate would perhaps be a doting grandparent, living with their adult children and offspring.

As gilts are all about security and predictability, the selection criteria you use when choosing them are substantially different from those required for equities. They should be informed exclusively by both your opinion concerning future inflation and interest rates, and your personal tax position. So, if you expect interest rates to rise, don’t consider gilts beyond the short and medium ranges – otherwise you risk locking into an investment paying interest below that available in a deposit account, and you would also sustain a capital loss unless you held the bond to redemption. Conversely, if you anticipate deflation, then consider a longer-term gilt.

Second, a gilt that is suitable for a non-tax payer isn’t necessarily appropriate for a tax payer at either the 20 per cent or 40 per cent rate. Non-tax payers can consider buying above-par values because the higher gross redemption yields (GRY) are less attractive to other investors, whereas both standard-rate and high-rate tax payers should look for gilts trading below par because the uplift to par is exempt from capital gains tax. If you are unfamiliar with the mechanics of the gilt market, you should take professional advice before committing yourself.

Source: http://www.investorschronicle.co.uk/2011/12/06/bonds-and-forex/news-and-analysis/bonds-what-are-gilts-A86NIdSP1xNf8SrbhkTVdJ/article.html;jsessionid=3F80D074494D95B7F9D7397F361E3361.mps-apr-02-8109