What it means
The label is about credit quality rather than about a particular issuer. In practice it covers bonds from stable national governments and from the small group of companies carrying the highest ratings from the credit rating agencies, typically the AAA and AA bands.
Safety in a bond means the interest arrives and the capital comes back, and it is measured through the issuer's track record, the strength of its cash flows and its ability to raise money in a crisis. A borrower that has never missed a payment through several recessions earns a cheaper cost of debt as a result.
The trade-off is yield. Investors buying a gilt-edged bond are effectively paying a premium for certainty, so these bonds typically pay one to four percentage points less than lower rated corporate debt of similar maturity.
Low credit risk does not mean no risk. Gilt-edged bonds are highly sensitive to interest rates, because when market yields rise the fixed coupon on an existing bond becomes less attractive and its price falls, and long dated bonds fall the hardest.
Inflation is the other quiet danger. A bond paying a fixed 4% is only worthwhile while inflation stays well below that, and a run of high inflation can leave a perfectly safe bond delivering a negative return in real terms.
In practice
Real-world examples.
Example
An insurance company matching long term claim liabilities buys $50,000,000 of gilt-edged government bonds maturing in fifteen years. The yield is modest, but the timing certainty of the cash flows is what the actuaries need, so credit risk matters more than headline return.
Example
A charity's investment committee moves a quarter of its endowment out of corporate credit into gilt-edged bonds after deciding it cannot risk a shortfall in its grant-making budget. It accepts a drop in portfolio yield from 5.1% to 4.0% in exchange for far greater certainty of income.
Example
A treasury team parks $8,000,000 of surplus cash in short dated gilt-edged bonds ahead of a planned acquisition. It deliberately chooses two year maturities rather than ten year ones, because a rise in interest rates would knock far more off the price of the longer bond if the money were needed early.
Formula
Calculation
Bond price = (coupon x annuity factor) + (face value / (1 + yield) to the power of n)
where the annuity factor = (1 - (1 + yield) to the power of -n) / yield
A gilt-edged bond has a face value of $1,000, pays a 4% annual coupon of $40, and has five years to maturity. The market yield for bonds of this quality has fallen to 3%.
(1.03 to the power of 5) = 1.159274, so 1 / 1.159274 = 0.862609.
Annuity factor = (1 - 0.862609) / 0.03 = 0.137391 / 0.03 = 4.5797.
Present value of the coupons = $40 x 4.5797 = $183.19.
Present value of the face value = $1,000 x 0.862609 = $862.61.
Price = $183.19 + $862.61 = $1,045.80.
The bond trades above its face value because its 4% coupon beats the 3% the market now demands. Compare that with a lower rated corporate bond of the same maturity yielding 6.5%: on a $1,000,000 holding, the extra 3.5 percentage points is $35,000 of additional income a year, which is the price the investor is paying for the extra safety of the gilt-edged bond.Case study
Seen in the real world.
This illustrative and fictional case concerns the invented Thorneside Foundation, an endowed charity funding medical scholarships. Its trustees held $30,000,000 entirely in gilt-edged bonds on the reasoning that a charity should take no credit risk at all, and for years the portfolio yielded a dependable 4%, or $1,200,000 a year.
When market yields rose sharply over an eighteen month stretch, the fictional trustees discovered that safe does not mean stable. The portfolio's average maturity was twelve years, and the rise in yields cut its market value by roughly 15%, from $30,000,000 to about $25,500,000. Not one issuer had missed a payment.
Because the foundation intended to hold the bonds to maturity, the paper loss did not affect its scholarship budget, and the maturing bonds were reinvested at the new higher yields. The illustrative lesson the trustees took was to shorten and stagger maturities so that the endowment would never again be forced to explain a $4,500,000 fall in value on a portfolio with no credit losses whatsoever.
Watch out
Common mistakes.
- Treating gilt-edged as meaning risk free, when the bond is only protected against default and remains fully exposed to interest rate and inflation risk.
- Assuming the top rating is permanent, since issuers are downgraded from time to time and a downgrade will move the price before most private investors notice.
- Buying long dated gilt-edged bonds with money that might be needed soon, which converts a safe holding into a real loss if it has to be sold after yields rise.
Questions
People also ask.
Is a gilt-edged bond the same as a gilt?
A gilt specifically means a bond issued by the UK government, while gilt-edged bond is the broader quality description that can also cover top rated corporate issuers.
Why would anyone accept the lower yield?
Because certainty has value for anyone with fixed future obligations, such as an insurer or a pension fund, and because these bonds tend to hold up when riskier assets fall.
How can I tell whether a bond qualifies?
Look at the credit rating and the issuer's payment history, with the top two rating bands generally regarded as gilt-edged territory.
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