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.