What it means
Historically the phrase referred to British government stock, whose certificates carried gilded edges, and it later broadened to any security of comparable standing. Today it is used loosely across markets to mean the top tier of fixed income, with credit ratings providing the formal dividing line.
What earns a security the description is the strength of the promise behind it. That means a government able to tax and to borrow at will, or a company with steady cash flows, low borrowings and decades of uninterrupted payments through several economic cycles.
Institutions hold these securities for reasons that go beyond return. Pension funds and insurers use them to match known future obligations, banks hold them because regulators treat them as high quality liquid assets, and treasurers use them because they can be sold in size quickly without moving the price much.
The cost of that quality is income given up. Moving a portfolio towards gilt-edged securities cuts the yield, and over long periods it also cuts expected total return, which is precisely why few investors hold nothing else.
Two nuances trip people up. Ratings can and do change, so a security that was gilt-edged when bought may not be five years later, and the safest bonds carry the greatest sensitivity to interest rates because their long maturities and low coupons magnify the effect of a yield move.
In practice
Real-world examples.
Example
A commercial bank holds $600,000,000 of gilt-edged government securities in its liquidity buffer. The yield is low, but regulators count these assets at close to full value when testing whether the bank could survive a month of deposit outflows.
Example
A defined benefit pension scheme with pensions in payment holds two thirds of its assets in gilt-edged securities of matching maturities. The trustees are not trying to beat a market index, they are trying to make sure a payment due in eleven years is definitely there.
Example
A family office selling a business parks $25,000,000 of the proceeds in short dated gilt-edged securities for eighteen months while it decides on a long term plan. The priority is that the capital is intact and accessible, not that it earns the highest available return.
Formula
Calculation
Blended portfolio yield = (weight in gilt-edged x gilt-edged yield) + (weight in other assets x their yield)
An institution holds $2,000,000, split 70% into gilt-edged securities yielding 3.2% and 30% into medium grade corporate bonds yielding 6.4%.
Blended yield = (0.70 x 3.2%) + (0.30 x 6.4%) = 2.24% + 1.92% = 4.16%.
Annual income = $2,000,000 x 4.16% = $83,200.
Checking it directly: ($1,400,000 x 3.2%) + ($600,000 x 6.4%) = $44,800 + $38,400 = $83,200.
Suppose the investment committee becomes nervous and shifts ten percentage points into gilt-edged, moving to an 80/20 split.
Blended yield = (0.80 x 3.2%) + (0.20 x 6.4%) = 2.56% + 1.28% = 3.84%.
Annual income = $2,000,000 x 3.84% = $76,800.
The move costs $83,200 - $76,800 = $6,400 of income a year, a reduction of 7.7%. That figure is the explicit price of the extra safety, and it is the number a committee should weigh against the size of the credit loss it is trying to avoid.Case study
Seen in the real world.
Here is an illustrative and entirely fictional example. Netherby Mutual, an invented insurance company, wrote annuity policies committing it to fixed monthly payments for decades. Its investment team was measured on portfolio yield, so it steadily reduced gilt-edged securities from 75% of assets to 45% and replaced them with higher yielding lower rated corporate bonds.
The switch raised the portfolio yield from 3.6% to 5.1%, worth an extra $12,000,000 a year on an $800,000,000 portfolio. For three years the strategy looked sound, and the fictional team was praised for closing a funding gap without asking shareholders for capital.
In the fourth year of this illustrative story a credit downturn produced defaults and downgrades across the lower rated holdings, and the portfolio lost roughly $70,000,000 of value, far more than the $36,000,000 of extra income it had generated. Worse, Netherby had to sell assets into a falling market to meet annuity payments. The invented board rewrote the mandate to require that all obligations falling due within ten years be matched by gilt-edged securities, on the principle that promises with fixed dates should be backed by assets with fixed outcomes.
Watch out
Common mistakes.
- Reading gilt-edged as a guarantee, when it is a judgement about credit quality that can be downgraded and says nothing about price movements before maturity.
- Chasing yield within the category by buying much longer maturities, which raises interest rate risk substantially while adding only a little income.
- Applying the label to shares in well known companies, since ordinary equity carries no promise of payment at all and sits outside the category however famous the business.
Questions
People also ask.
Are gilt-edged securities and investment grade the same?
Investment grade is a much wider band that reaches down to the lowest acceptable rating, whereas gilt-edged usually means only the top of that band.
Can a company's bonds be gilt-edged?
Yes, though very few companies now hold the highest ratings, so most gilt-edged securities in practice are government issues.
What proportion of a portfolio should be gilt-edged?
It depends on how fixed your future obligations are, with insurers and mature pension schemes holding a great deal and long horizon investors with flexible spending holding much less.
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