2.3.1 Gilts: UK government bonds

An important form of bonds are those issued by the UK Government through the Debt Management Office (DMO).

These bonds are known as ‘gilts’ or ‘gilt-edged stock’, reflecting both the gold gilt that used to be set around the edge of the bonds and the fact that they are generally accepted as being an investment with no realistic risk of default by the issuer (the UK Government).

Most gilts offer a fixed-rate coupon to investors – paid semi-annually and most are issued with maturities of between 5 and 30 years. Some gilts have a zero coupon, though, which means that investors receive no income stream from them. These are issued at a discount so the return to the investor if held to maturity is the difference between the discounted price paid on purchase and the face value paid back on the maturity date.

Some gilts have no maturity date. These ‘undated’ gilts, sometimes also called ‘consols’, just pay an income stream to investors in perpetuity or until the UK Government decides to cancel them and repay investors. This has happened recently. In February 2015, £218 million of undated gilts issued in 1927 to help refinance debts arising from the First World War were redeemed. The Government is also looking closely at the case for redeeming £2 billion of other undated gilts issued after the First World War. The reason for these developments is financial rather than emotional, despite the centennial anniversary of the war, the cost of these gilts to the Government is now higher than the cost of newly issued gilts given in the UK’s current low interest rate environment.

Gilts are marketable and can be traded at any point up to their maturity. As a consequence, the capital price of gilts will move in accordance with market movements. The key relationship here is that the capital price of a gilt will move inversely to movements in interest rates.

Let’s try an example. Let’s say that in 2015 a 10-year gilt was issued paying an annual coupon of 6% per annum. For this example, the face value of the gilt is £100. In this case, £100 is what it cost to buy on the issue date and this is what it will return to the investor holding the bond on its maturity. Note, though, that gilts may be sold on their issue date at a discount or premium to their face value.

Five years later, in 2020, interest rates have fallen such that new 5-year gilts could be issued at an annual coupon of 2% per annum. However, that 10-year gilt issued in 2015, which has 5 years to run until maturity, still pays investors 6% per annum as the coupon is fixed for its life.

So what should have happened to its capital price that was £100 on its issue date? The answer is that it would have risen to reflect the fact that investors will receive 4% more from holding this gilt (with its residual life of 5 years) than they will get from buying a newly issued 5-year gilt.

In very crude terms investors will be happy to pay roughly 20% more than the face value of £100. This equates to the 5 years of higher interest (5 years × (6% - 2%) = 5 years × 4% = 20%) they will receive holding the 6% coupon gilt than the 2% coupon gilt. In approximate terms, the price would rise to £120.

Now, on maturity, the investor would still only get back the £100 face value, generating a capital loss of £20. But this loss is fully compensated for by the higher coupons received during the 5 years of £20 in total (5 × 4% × £100 = £20).

The overall return or yield – or gross redemption yield (GRY) – to the investor ends up being £30 (5 years × 6% × £100 = £30) less the capital loss of £20 – a net total of £10. This matches the return over the 5 years of 2% on the newly issued gilt (5 years × 2% × £100 = £10).

So, while the coupon offers 6% per annum, the overall yield to the investor from buying the 6% coupon gilt with a residual life of 5 years matches the market rate for a new 5-year gilt of 2% per annum.

Note that the maths is a little approximate here – the exact returns would have to take into account the timings of the coupon payments. In the first example above, the exact price that the £100 6% coupon gilt would have risen to, with 5 years to maturity and a prevailing rate of return for 5 year gilts of 2% per annum, would be £118.85. This is achieved by discounting future cash flows relating to the bond by the prevailing market yield. This is a little complex. But the principle is clear: the capital price of existing fixed interest rate bonds moves inversely to movements in the prevailing rates of interest.