Gilts - Index Linked

stv1x

I've taken a look at the UK Debt Management website http://dmo.gov.uk/index.aspx?page=About/About_Gilts and, whilst informative, still find the subject confusing.

Can anyone offer an idiots guide for someone wishing to invest in them with the pros and cons?

Cheers :beer:

Aegis

stv1x wrote: »

I've taken a look at the UK Debt Management website http://dmo.gov.uk/index.aspx?page=About/About_Gilts and, whilst informative, still find the subject confusing.

Can anyone offer an idiots guide for someone wishing to invest in them with the pros and cons?

Cheers :beer:

Pros:

You know exactly what income you will get out of directly held gilts
You know exactly what the capital value will be worth at the end of the term (i.e. if held to redemption)
They're backed by the UK government and are therefore rather unlikely to fail to pay
If held in an ISA they will be entirely tax free

Cons:

If you intend to sell them before the final redemption date, the capital value of the gilt is variable
The overall yield can be difficult to calculate if you're unused to the idea that the income is based on the nominal value, not necessarily what you paid for it


An additional fact is that these tend to rise and fall in value without being correlated to the stock market, so if you're looking for a little diversity they can be useful. On the other hand they're unlikely to give stunning returns compared with equities.

krlest

Hi, I have also been looking at buying index linked gilts but I am getting confused on one point...

Taking the following as an example:
Auction of £1,200 million of 1 7/8% Index-linked Treasury Gilt 2022:- from the DMO website.

"The amount payable on application in the case of a non-competitive bid made by a member of the Approved Group is £135 per £100 nominal of the Gilt."

So reading the above, I understand I will have to pay £135 or slightly less per £100 nominal... I'm probably not understanding something... but doesn't that make the purchase of this particular gilt via auction impossible to see a return that is greater than inflation adjusted redemption amount?

Thanks in advance for any help

Masomnia

Aegis wrote: »

Pros:

You know exactly what income you will get out of directly held gilts
You know exactly what the capital value will be worth at the end of the term (i.e. if held to redemption)
They're backed by the UK government and are therefore rather unlikely to fail to pay
If held in an ISA they will be entirely tax free

Cons:

If you intend to sell them before the final redemption date, the capital value of the gilt is variable
The overall yield can be difficult to calculate if you're unused to the idea that the income is based on the nominal value, not necessarily what you paid for it


An additional fact is that these tend to rise and fall in value without being correlated to the stock market, so if you're looking for a little diversity they can be useful. On the other hand they're unlikely to give stunning returns compared with equities.

Surely you don't know what your return will be with index linked gilts?

Loughton_Monkey

krlest wrote: »

So reading the above, I understand I will have to pay £135 or slightly less per £100 nominal... I'm probably not understanding something... but doesn't that make the purchase of this particular gilt via auction impossible to see a return that is greater than inflation adjusted redemption amount?

Thanks in advance for any help

It can look like a 'complicated' market, but deep down it's very simple.

Start by looking at an ordinary bank fixed rate 1 year bond. Maybe it pays 3.25%. You put in your £1,000 on January 1st. On the next January 1st, you can draw out exactly £1,032.50. [ignoring tax].

As you know, with this bank, you must leave it there for the full period.

Gilts are exactly like this. But they are much longer term, and also you can sell them mid-term.

So just go back to your bank fixed rate which you bought 1st January. Imagine you need the money on 1st March, at which point even Mickey Mouse could get 4% on a 1 year bond. So why am I going to pay you the full £1,000 for your bond? I'm not. I'm going to pay you whatever price it takes to earn me 4%.

Hence you agreed to invest at 3.25% for a year. After this, interest rate went up. So 3.25% is what you'll get. Not a penny more. If you sell it to me, and I want 4%, then for the small period you owned the bond, you are getting much less than even the 3.25% you were 'happy' with.

So it's the same with Gilts. The government will issue one at, say 4.5%. This is what they will pay. Annually. On the nail. No problem. If you keep it to maturity, then you will truly have received 4.5%.

If interest rates go up, then the price goes down to match. So you can only sell it at a price that represents, say, 5.5% for the remainder of the term. Since the government has truly paid only 4.5% total, and the new owner is receiving 5.5%, then the original holder gets much less than the 4.5% originally 'agreed'.

The moral of this story is that you would only invest (rationally) in Gilts under three curcumstances. 1. You are 'happy' with the return, 2. You keep it until maturity, or 3. You think interest rates will go down.

SInce I do not believe item (3), I wouldn't touch any long term fixed interest (Gilt or no Gilt) with a bargepole. Interest rates are only going one way. To invest long term at today's interest rate seems to me a trifle silly.

Reaper

Loughton Monkey, your explanation is good for normal gilts, but the question is about index linked gilts which are a different kettle of fish.

Loughton_Monkey

Reaper wrote: »

Loughton Monkey, your explanation is good for normal gilts, but the question is about index linked gilts which are a different kettle of fish.

Understood, but I think some of the same principles apply.

Reaper

Loughton_Monkey wrote: »

Understood, but I think some of the same principles apply.

Indeed, just more complicated. If anybody is a complete sucker for punishment the DMO has a PDF document that explains how it thinks they should be priced, but really I don't recommend it.
Don't click here, it will fry your brain.

Aegis

Masomnia wrote: »

Surely you don't know what your return will be with index linked gilts?

Well, you know what the inflation adjusted return (as measured by RPI) will be, but not the nominal return, so the answer is a bit of yes and a bit of no.

Reaper

krlest wrote: »

Auction of £1,200 million of 1 7/8% Index-linked Treasury Gilt 2022:- from the DMO website.

"The amount payable on application in the case of a non-competitive bid made by a member of the Approved Group is £135 per £100 nominal of the Gilt."

Looking it up quickly the current price seems to be about £115. That is still on the high side I reckon unless you believe double digit inflation is on the way, but I guess for large investors wanting a safe place to store their money there isn't much choice. Pretty much everything else could go down in value (cash, gold, shares etc). Perhaps they feel it is worth taking a small hit in exchange for certainly. Can't say it apeals to me though.

barak

Reaper wrote: »

Loughton Monkey, your explanation is good for normal gilts, but the question is about index linked gilts which are a different kettle of fish.

They certainly are! I find Index-Linked Gilts quite difficult to understand - my limited experience of them as a trustee being advised by a broker made me think that they should be left strictly to the professionals.

So they are now covered by my Rule 2. which is never to invest in anything I don't fully understand.

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