The yield on a gilt is the rate of return that an investor can expect to receive for holding the gilt, and is therefore an important investment calculation.
There are various ways to calculate gilt yields, depending upon what yield figure an investor is looking to compare. In general, the majority of the information is contained in the name of the gilt although there are various factors to consider, such as inflation for index-linked gilts and the fact that some gilts are undated, i.e. they have no fixed redemption date.
There are three main types of yield calculation, which may need to include assumptions for any unknown future values. These are interest rate (or coupon) yield, current yield (also referred to as the running yield) or redemption yield (also referred to as the yield to maturity)
The interest rate yield
The interest rate yield is very simple to calculate and is essentially the rate of interest that is paid on the gilt at the date of issue. This interest rate is given in the name of the gilt when it is issued.
For example, the 4% Treasury Gilt 2022 pays 4% interest per annum until it matures in 2022. The interest rate yield on this gilt is therefore 4% – for every £100 of gilt that you hold as an investor you will receive £4 per annum in interest payments.
The current yield
Once gilts are issued they can be traded in the secondary market and the price to purchase them varies with expectations of the economy, the rate of inflation and interest rates. For example, if there is an expectation that interest rates are going to rise, the price of gilts will fall, and vice versa. This also impacts gilt yields, as the interest payments are set when the gilts are issued.
To calculate the current gilt yield, the annual interest payment on the gilt is simply divided by the current market price of the gilt. The market price is usually the “clean price”, i.e. the actual price to be paid – the “dirty price” includes an adjustment for any interest accrued on the gilt at the time it is traded.
So, if the 4% Treasury Gilt 2022 is trading at £95 for every £100 of nominal value, then the current yield is £4 (annual interest) divided by the current £95 purchase price = 4.21%.
The redemption yield
This is a much more useful measure for investors to be able to compare gilt yields across different gilts. This is the internal rate of return of a gilt and takes into account the prevailing market price, the timing and amounts of interest payments still to be made and the amount of capital repayment due when the gilt matures.
There are certain factors specific to some types of gilts where assumptions need to be made, such as index-linked gilts where future assumptions on inflation are needed, and double dated or undated gilts where an assumption needs to be made about a redemption date.
If no assumption about a redemption date is realistic (usually because the interest rate is so low, such as the well known 3½% Undated War Loan that was issued in December 1932, or the less well known 2½% Consolidated Stock that was first issued in April 1888 and still has £167 million nominal value outstanding) then there is an infinite cash flow formula that can be used to calculate gilt yields, which is available on the DMO website.
By understanding how to calculate gilt yields, an investor can meaningfully compare the returns available from investing in gilts and make a more informed investment decision.
UK gilts are bonds issued by the UK government for the purpose of financing the shortfall between public spending and tax revenues and there are a number of different types of UK gilts currently in issue.
UK gilts are very highly rated by all of the main credit ratings agencies (AAA as at November 2012) and the prices to buy gilts fluctuate on a daily basis during market trading, mainly based on the outlook of the interest rates. All UK gilts are unconditional obligations of HM Treasury and before investing in them, it is very important that you are aware of the various types and their unique features.
Conventional gilts are the most common type of UK gilts, accounting for just over 81 per cent of outstanding UK government debt. These gilts guarantee to pay a fixed cash coupon to the holder two times a year and at maturity, together with repayment of the nominal amount of the gilt.
Conventional gilts can extend as long as 50 years or be as short as just a few months. The dates are generally categorised as follows:
- Ultra-Short dated gilts – maturity in 3 years or less
- Short dated gilts – maturity from 3 years up to 7 years
- Medium dated gilts – maturity from 7 years to 15 years
- Long dated gilts – maturity over 15 years
For the private investor, the most popular length of investment will normally be between 2 years and 10 years. A small number of these conventional gilts feature more complicated aspects, such as calls that let the UK government pay off debts well ahead of time.
Perpetual or Undated Gilts
The main difference between perpetual or undated gilts and conventional gilts is the lack of a maturity date. These UK gilts were issued with no set maturity date, and they can be paid back at the discretion of the UK government. These are the oldest gilts within the UK gilts portfolio and because they are so old, they have very low coupons, making it less attractive to the government to redeem them, as they are receiving cheap borrowing.
Due to this unique aspect of these UK gilts, the holder is dependent on the market price if they decide to liquidate their investment and perpetual or undated gilts should therefore be considered riskier than conventional gilts. They also tend to be more volatile than conventional gilts, with the most popular among them being the UK 3.5 percent War Loan, which still has £1.9bn in issue.
Issued for the first time back in 1981, index-linked gilts are different from conventional gilts due to the way that the coupon payments and principal are calculated. Rather than these being a fixed amount, set at the date of issue, both the principal and the semi-annual coupon payments are adjusted with reference to the RPI, or the General Index of Retail Prices in the UK.
Since September 2005, there has been a 3 month time lag on the RPI used in the calculation of indexation on the coupon and the principal. This was an 8 month indexation lag on gilts issued before that date. These investments provide a shelter against the threat of inflation and it is not uncommon for these gilts to display a greater price movement over time, mainly because of this inflation-linking factor.
As with any investment, it is always advisable to fully research and understand the complete details of the issue before investing. Prospectuses for any UK gilts issues can be found on the website of the UK government’s Debt Management Office.
The history of British gilt edged securities can be traced back to the need for governments to raise capital. In essence, these gilts are bonds that are issued by a government to fund the shortfall between its tax revenues and its expenditure.
The term “gilt edged securities” is actually a British phrase that was initially a reference to debt securities that were issued by the Bank of England. These original debt securities featured a gilded edge, leading to the name of gilt edged securities.
In the present day, the phrase gilt edged securities is used in the UK, but also in some of the Commonwealth countries like India and South Africa. However, when a security is referred to as a gilt, it is generally a reference to the bonds issued by the UK government.
While these gilts were originally certificates with gold-leaf trimming, today they are traded in electronic form. Conventional Gilts are the simplest version of UK government bonds and account for the largest portion of outstanding UK government debt, at just over 81 per cent, according to the data from the Debt Management Office.
These conventional gilts have been around for some time – according to The Gilt-Edged Market by Choudhry, Cross and Harrison, the first fund raising that could be considered a gilt issue was in 1694 when King William III borrowed £1.2m to fund a war against France.
However, specific kinds of gilts, at least in the UK, such as index-linked gilts were first issued in 1981, with the UK being one of the first developed economies to do this. Index-linked gilt edged securities account for the next largest proportion of the UK government debt, at around 18%.
As it stands today, the UK government is raising around 170 billion pounds gross every year (around 115 to 130 billion pounds net issuance) through gilt auctions. This increased significantly following the financial crisis in 2008 and peaked at 227 billion pounds gross issuance in the Financial Year 2009 / 2010.
From the very first gilt issuance way back in 1694, the size of the national debt of the UK has grown, which is similar to many developed economies. This growth has been more extreme in recent years however. To illustrate this, in March 1998, the total stock of outstanding gilts was 418 billion pounds. However, as at November 2012, the outstanding stock of gilts has increased to just under 1.2 trillion pounds – an increase of 187% in just over 14 years.
Today, the statistics also provide a very reliable picture of which investors hold UK gilt edged securities, with around two thirds of all UK gilts now being owned by either pension funds or insurance companies. Since 2009, there have also been large amounts of gilts issued and re-purchased by the Bank of England by way of its policy of quantitative easing.
Investors who are interested in gilt edged securities are able to invest through their brokers or via a fund. It is also possible to invest in gilts directly through the Debt Management Office, which replaced the Bank of England as the issuer of these gilts in April 1998.
In the United Kingdom ‘gilts’ were originally debt securities from the Bank of England with gilded edges, hence the name. The term is used throughout modern Commonwealth nations, but is most generally associated with the UK.
Most modern gilts in the United Kingdom are held by insurance companies and pension funds, and account for around thirty percent of government debt. Anyone who wants to diversify their business portfolios and return on their investments in a secure manner should consider saving bonds of this type.
Gilts are among the simplest government bonds in the United Kingdom: holders receive fixed amounts twice a year until the bonds mature, and then the holder receives the principal. They are widely viewed as safer than other types of government bonds, particularly in troubled economic times and can be thought of as loans to be repaid after their investment periods are over.
As the government is unlikely to default on their debt, they are generally regarded as safe investment choices. The United Kingdom government in particular has an excellent track record for honouring its debts.
The investment periods of gilts can be extremely variable. Some bonds can have maturity dates of fifty years, whereas others may only be for one year, although they are usually for periods of between five and thirty years. There are also some undated gilts, which have no fixed maturity date, but these now account for a very small proportion of the UK government’s debt.
The fixed interest or coupon payments on the gilts are usually paid every six months, and you can immediately tell what the coupon rate and the maturity date are by the naming of the gilt. For example, the 4¼% Treasury Gilt 2027 has a 4¼% coupon rate, i.e. it pays £4.25 per annum, split into two payments, for every £100 of gilt held, and matures in the year 2027.
Many gilt holders will sell them before they reach maturity, and this course of action doesn’t generally incur any additional charges. However, as with all investment decisions, it is advisable to speak with a qualified financial planner or financial consultant for any professional advice. Anyone considering investing in gilts can look at direct investment into the gilt market or an indirect investment through gilt funds.
As the government’s funding plans can change substantially over the course of decades, there are times when it may be more or less economical to sell gilts rather than hold them until maturity to receive repayment of the nominal amount.
The value of gilts can rise and fall with the stock market, since they can be bought and sold there, although the main drivers of the price of a gilt are the interest rate or coupon payable relative to general interest rates, and how close the gilt is to maturity.
For gilts with some time to run, if the interest rate is more attractive than general interest rates, it is likely to trade at a premium, i.e. higher than the nominal value of the gilt, and the opposite is true when the coupon rate on the gilt is less attractive than general interest rates, i.e. it will sell below the nominal value.
It is important to work out the interest payments that you will receive until maturity and the nominal value that you will receive to ensure that you will not make a loss on any investment, especially if you decide to invest in a gilt where the price is trading above the nominal value.
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