Investing for Income 

Bonds: 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.

What to buy

The first concept to understand is the gilt 'yield curve', which is simply a graph plotting the relationship between gilt yields and their maturity dates.

The above graph merely differentiates gilts in issue by maturity and redemption yield (RY). The market convention is to divide gilts into three maturity categories: shorts (one to seven years), mediums (seven to 15 years), and longs (15 years plus). As they're traded daily, the shape of the yield curve changes in line with current prices. Prices are generally quoted per £100 'nominal' of the gilt – the 'nominal' refers to the gilt's 'face value', which is the amount that will be repaid when it matures. The RY is the return implicit in the current market price of the gilt, assuming that it is held to its redemption and that all interest payments are reinvested back into the bond. It also includes the capital gain, or loss, from holding the gilt until maturity, depending on whether you purchased the gilt at a price below, or above, £100. The RY is the standard measure used in bond markets for comparing rates of return on investments with the same maturity. Fortunately, though, you don't need to calculate the RYs for yourself, as they are quoted daily online by the Debt Management Office (DMO) at www.dmo.gov.uk/gilts.

As you can see from the graph, the yield curve is 'inverted' - it slopes downwards after 2011. Textbook theory, however, suggests that it should slope upwards from left to right, with longs yielding more than either shorts or mediums to compensate for the inherent risk of future inflation corroding the value of any long-term fixed-interest security. The current shape of the curve may seem puzzling. However, while gilts are essentially absolved of default risk (unlike corporate bonds), their prices (and thus yields) are determined by supply and demand factors, as well as by expectations of inflation and interest rates. So the shape of the yield curve at any moment is, therefore, a function of supply and demand characteristics at different gilt maturities.

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.

All essential information on gilts is available on the DMO website. Here, you can find descriptions of all the gilts currently in issue, and the RYs on individual stocks.

How to Buy

The most obvious route is via a stockbroker or bank. If you are new to the gilt market, this is probably the most sensible route. Inevitably, you will have to pay commission charges. At the same time, though, their advice can be hugely beneficial to investors with little experience of gilts.

Alternatively, you can trade in the 'secondary' market via the DMO's Retail Purchase & Sales Service. But, in order to access this service, you will need to become a member of the Approved Group of Investors. The process is relatively straightforward, although it will require you to complete various forms to vouch for your 'bona fides'. The relevant forms are available from either the DMO, or Computershare (www.computershare.com/uk/investor/gilts). Computershare is an agent of the DMO and provides an execution-only service.

For those who are already members of the Approved Group of Investors, it is possible to participate in the 'primary' market, although buying at DMO auctions is not recommended for private investors who are unfamiliar with the mechanics of the gilt market. A calendar is published up to a year in advance and bids are either 'non-competitive', or 'competitive'.

Finally, you might consider a gilt fund. Here, you must expect both the annual and management charges to impact your returns. However, you would benefit from exposure to a diversified portfolio of stocks.

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