How investments work - gilts

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My aim when I set off with this project was to post every couple of weeks but that is proving difficult so I will try my best and if it slips to three weekly sometimes then please bear with me.

When a government’s tax receipts are not enough to cover its spending it needs to borrow money. This is done by the Debt Management Office. They issue gilts which investors can buy; the investors are lending money to the government. They will want to see something in writing that proves they have made the loan, what the interest rate is and when they will get their money back. The piece of paper that does this is a “Gilt”. (The term Gilt is historic and comes from the days when they were described as “gilt-edged securities”, which in turn is because the piece of paper had a gold band on the edge.)

As Gilts are loans it is important to understand what that entails.

If you were lending money to a complete stranger you would want to see some form of security in case the person failed to pay you back. You would also want interest on the loan until it is repaid as compensation. Whilst your borrower might have the best of intentions to repay you things can go wrong. Being unexpectedly redundant, for example, can change priorities dramatically. The security (or collateral) is something of value that is usually worth at least as much as the loan so that, if you never see your money again, you can sell it and recoup your loss. Banks and building societies take your home as security when they give you a mortgage for this very reason. They take a legal charge which means you cannot sell the property unless they agree to it. If you default they can go to court and take possession of your property and sell it.

When looking at borrowing and lending remember t - the higher the risk the higher the interest rate and the lower the risk the lower the interest rate.

When you lend money to the government though, it is slightly different. The government is not going to be made redundant and if it needs more money it can always raise taxes. In other words, your money is pretty safe if you lend it to the UK government; historically the UK government has never failed to repay its debt, both interest and capital.

The people who raise money for the government are known as the Debt Management Office (DMO). Their website offers the following description:

Gilts are marketable sterling government bonds issued by the DMO on behalf of the UK Government as part of its debt management responsibilities.[i]

It doesn’t really tell you what you need to know. If you follow the links on the DMO website it leads you to this:

Conventional gilts

Conventional gilts are the simplest form of government bond and constitute the largest share of liabilities in the Government's portfolio. A conventional gilt is a liability of the Government which guarantees to pay the holder of the gilt a fixed cash payment (coupon) every six months until the maturity date, at which point the holder receives the final coupon payment and the return of the principal. The prices of conventional gilts are quoted in terms of £100 nominal. However, they can be traded in units as small as a penny.

A conventional gilt is denoted by its coupon rate and maturity (e.g. 4% Treasury Gilt 2016). The coupon rate usually reflects the market interest rate at the time of the first issue of the gilt. Consequently there is a wide range of coupon rates available in the market at any one time, reflecting how rates of borrowing have fluctuated in the past. The coupon indicates the cash payment per £100 nominal that the holder will receive a year. This payment is made in two equal semi-annual payments on fixed dates six months apart (these payments are rolled forward to the next business day if they fall on a non-business day). For example, an investor who holds £1,000 nominal of 4% Treasury Gilt 2016 will receive two coupon payments of £20 each on 7 March and 7 September.

If you struggled to understand what that all means I think you’re probably in good company. Remember in episode 1 I said my world was full of bullshit – there is the proof!

So let me try and simplify it.

You lend the government £100 until 2021 which they guarantee to pay back to you. Between now and then they will pay you 4% interest a year (known in the investment world as the “coupon”) on the £100 you have lent them. 4% of £100 is £4 and it is paid in two instalments each year, so you get £2 every six months.

Gilts are “fixed interest” investments, which means that the interest rate they pay does not change even if the Bank of England changes the base rate. Any changes in base rates will affect the rates offered on new issues of gilts, but it cannot change the interest rates on the ones that are already out there. This is like fixed interest accounts at banks and building societies. But there is a significant difference – bank and building society accounts are not “tradable”. What does that mean? Simply that you cannot sell your bank account to someone else. You can, however, sell your gilt to someone else because it is “tradable”. And that makes gilts really interesting investments!

Let’s use the example earlier with a rate of 4% and a value of £100 that will be paid back to you in 2021. That 4% is fixed and is based on the £100. If you held that investment for a full two years you would receive £8 in interest payments (two times £4) and £100 return of capital, giving a total return of £108.

Let us suppose that when you bought the gilt the best two-year interest rates offered by the banks were 4% a year, the same as the gilt. (The only difference between the two investments is that one is guaranteed by the government without limit and the other is protected up to £85,000)

However, just 2 seconds after you bought your gilt, our chums at the Bank of England decided that inflation was under control. They reduced base rates, causing a drop in interest rates on two-year deposits to 1% a year. A new investor will now get £1 a year for two years on his £100 deposit at the bank, a total of £102 back, whilst you are still looking forward to getting £108 over the same period.

How much would someone be prepared to pay you to buy that gilt from you?

Would he pay you, say, £104? Let’s look at what he would get.

£104 invested today would give him two lots of £4 interest (be aware the interest rate is based on the £100 nominal value on the gilt, not on the amount he pays for it) and £100 return of capital after two years. Dave is going to lose £4 of capital in two years’ time but he doesn’t care because he is going to get £8 of interest. He makes a return of £4 (£8 minus the £4 loss) which is double the £2 he would receive from the bank.

Would you sell it to him? You might! You would make a profit of £4 in a day rather than waiting a year to see that return if you didn’t sell. But then where would you invest your £104 tomorrow that would give you a total return that equalled £108 over two years?

In the world of investments everything finds its own level, just like water running downhill. In the example above, you would expect to find a price which satisfied both you and Dave somewhere between £104 and £108 where you would both be happy. Before you go rushing out to buy a portfolio of gilts we need to look at what happens if interest rates move the opposite way.

What would happen if interest rates went up the moment after you bought the gilt above, and the bank now offers 8% a year for a two-year fixed deposit? Now an investor is looking at a total return of £116 over two years (two lots of £8 plus his money back) while you are looking pretty glum at the same old £108 return over the same period. Would you sell your gilt for less than you bought it for?

Would you sell it for £96? You might! You would lose £4 to start with (£100 paid for the gilt less £96) but you could then invest your £96 in the bank and get 8% a year, which on £96 would be a return of £7.68 a year (Yes trust me 8% on £96 is £7.68). Two years of £7.68 is £15.36; add that to your £96 and you would have a total return of £111.36, well above the £108 you were stuck with a minute ago! Sometimes making a loss is a good thing in the long run.

There are two ways of looking at gilts as an investment. You can buy them and keep them until they mature or you can buy them and hope to sell early for a profit. Buying and keeping hold of them means you know exactly what you will receive from your investment. If you buy and hope to sell early, you run a risk that you will not be able to make an early profit and will be forced to hold until the maturity date.

As we saw above the value of a gilt can get quite confusing - it is worth £100 on paper when it matures, but then it can end up being worth more or less than that once it starts trading. How on earth do you know the value of a gilt once it has started to trade? How will you know if it is good or bad value? The answer lies in what is called the “gross redemption yield”. This shows the annual return you would get if you bought the gilt today and held it until its maturity date as an annual return. It takes account of the £100 you will get back, the price you pay today to buy it and the half-yearly payments of interest that you receive. In short, it provides a number which you can compare to other interest rates on deposit and savings accounts.

Gross Redemption Yields

It might help to look at a couple of examples of how this works.

Example 1

Suppose you had a gilt which will pay back £100 in two years’ time and meanwhile an interest rate of 4.5% a year. It will cost you £102 on today’s market to buy it. The total return you get isn’t 4.5% because you will lose £2 when it matures. The gross redemption yield takes all that into account and in this case it is 3.45% a year.

Example 2

Suppose you were looking at the same gilt as above, but instead of it costing you £102 it cost £95? In that case you will make a profit of £5 in two years’ time and receive a return of 4.5% a year in the meantime. The gross redemption yield in this case is 7.28% a year. There are calculators online that will work all this out, which you can use free of charge - just type gross redemption yield calculator into your search engine.

The gross redemption yield allows you to easily compare the value of a gilt against a deposit account. In example 1 above, suppose you could find a deposit account paying 4.0% fixed for two years. You can see from the gross redemption yield of 3.45% that the gilt would pay you less. Even though the rate is 4.5% a year, the £2 loss of capital reduces the equivalent rate to 3.45%.

In example 2 above let us assume you found a bank offering a fixed interest deposit paying 6% a year. The rate looks much better on the face of it than the 4.5% from the gilt, but adding in the profit of £5 in two years’ time means the total return of 7.28% is much better.

We’ve covered some really important lessons in this chapter which deserve capturing in some more Golden Rules.

NB. I have ignored compounding in these calculations for simplicity.

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