What it means
Gilts are issued by the Debt Management Office on behalf of the Treasury, mostly through auctions to a group of approved dealers who then trade them on. They are quoted per 100 pounds of nominal value, so a price of 96.50 means you pay 96.50 pounds for every 100 pounds you will get back at redemption.
There are two main varieties. Conventional gilts pay a fixed coupon twice a year and repay a fixed sum at maturity, while index-linked gilts adjust both the coupon and the redemption amount in line with a published inflation measure, protecting the real value of the investment.
The yield on a gilt matters far beyond the people who own them. It is the reference rate against which corporate borrowing is priced, it feeds into fixed rate mortgage pricing, and pension schemes use long gilt yields to put a present value on pensions they must pay decades from now.
That last point produces a result many people find counterintuitive. When gilt yields fall, the calculated value of a pension scheme's future obligations rises, so a scheme can look worse funded even though nothing about its members or its investments has changed.
Gilts carry almost no default risk but plenty of price risk. Long dated gilts move sharply when interest rate expectations shift, and investors who bought at very low yields have seen large falls in market value even though every coupon arrived exactly as promised.
In practice
Real-world examples.
Example
A pension scheme buys 40,000,000 pounds of long dated gilts maturing in 2044 to match pensions payable around that date. The trustees are matching a liability rather than seeking a return, so the certainty of the redemption date is the whole point of the purchase.
Example
A cautious saver builds a ladder of short dated gilts maturing in each of the next five years. Each maturity releases capital that can either be spent or reinvested at whatever rates prevail, which reduces the risk of committing everything at one moment.
Example
A corporate treasurer pricing a new bond issue starts from the yield on the gilt of similar maturity and adds a credit spread of 180 basis points. If the gilt yields 4.2%, the company expects to pay roughly 6.0%, so a move in gilt yields directly changes its cost of borrowing.
Formula
Calculation
Running yield = annual coupon / clean price
Approximate yield to maturity = (annual coupon + ((redemption value - price) / years to maturity)) / price
An investor buys a conventional gilt with a nominal value of 1,000 pounds paying a 4.25% coupon, so the annual interest is 42.50 pounds, paid as 21.25 pounds every six months. The gilt is priced at 96.50 per 100 nominal, so the purchase cost is 965 pounds and there are three years left to redemption at 100.
Running yield = 42.50 / 965 = 4.40%.
The investor also gets a capital gain at redemption, because 1,000 pounds comes back against 965 pounds paid, a gain of 35 pounds. Spread over three years that is 35 / 3 = 11.67 pounds a year, or 11.67 / 965 = 1.21% a year.
Approximate yield to maturity = 4.40% + 1.21% = 5.61%.
Total cash received over three years is (42.50 x 3) + 35 = 127.50 + 35 = 162.50 pounds on an outlay of 965 pounds, which is where the difference between the 4.40% income yield and the 5.61% total return comes from. If the gilt had instead been bought above par at 104, the capital element would have been a loss and the yield to maturity would have fallen below the running yield.Case study
Seen in the real world.
The following is an illustrative and fictional example. The Ravensmoor Pension Scheme, an invented defined benefit scheme, reported a small surplus in a year when long gilt yields sat around 4%. Its liabilities were valued at 500,000,000 pounds and its assets at 510,000,000 pounds.
Over the next two years gilt yields in this fictional scenario fell to about 2%, which meant future pension payments were discounted at a much lower rate and their present value rose to roughly 700,000,000 pounds. The scheme's assets, which were mostly in equities and property, rose only to 560,000,000 pounds, so a 10,000,000 pound surplus became a 140,000,000 pound deficit without a single member changing their retirement plans.
The illustrative point is not that the scheme invested badly, it is that the scheme's obligations behave like a large holding of long gilts whether or not it owns any. Had Ravensmoor held more gilts, its assets would have risen alongside its liabilities and the funding position would have moved far less. The invented trustees subsequently adopted a matching policy, accepting a lower expected return in exchange for a funding level that no longer swung by hundreds of millions on a change in yields.
Watch out
Common mistakes.
- Believing gilts cannot lose money, when a rise in yields reduces the market value of an existing gilt immediately and long dated gilts can fall a long way.
- Confusing the coupon with the yield, since the coupon is fixed against the nominal value while the yield depends on the price actually paid.
- Assuming index-linked gilts protect against every inflation outcome, when they track a specific published index and can still lose value if real yields rise.
Questions
People also ask.
Why are they called gilts?
Because the original UK government bond certificates had gilded edges, which came to stand for the security of the borrower behind them.
Are gilts a good place for money I might need soon?
Short dated gilts are, since they mature quickly and move little in price, but long dated gilts can swing sharply and are unsuitable for money with a near term purpose.
How do gilts differ from Treasury bonds?
They are the same idea in different countries, with gilts issued by the UK government and Treasury bonds by the US government, and each acts as the benchmark risk free rate in its own market.
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