Index Link Gilt

phb71

Hello

I understood bond gives you a specific amount of interest after X years but I don't understand what the 'yield' is and I'm a bit confused about index link gilt and how they work. If someone could quickly explain, that'd be great!

Thank you

Ballard

A bond would have a price as well as an interest rate and both need to be used to calculate the yield.

A sterling bond issued today paying 5% would be very attractive to investors and consequently they would cost more than 100% of the face value (a premium). conversely a zero coupon bond wouldn't be so attractive and would be less than 100% (a discount). At maturity you'd get the face value (all being well!).

Reaper

Index Linked means it will pay out the rate of inflation plus an amount on top.

As you can imagine something like that is popular so if you try to buy one you will have to pay over the odds.

For example there might be a £100 gilt paying out (at the current rate of inflation) 2%pa. You might think that is worth it as it will rise with any future inflation.

However when you try to buy it on the open market you find you have pay £200 to get hold of it. That effectively means you are now getting a 1% return on the money you paid for it.

When you eventually come to sell it you might get more or less than the £200 you paid for it depending on demand (which will depend on what inflation and interest rates are at the time).

Many gilts and bonds have a fixed period after which they are redeemed at the face value. So in the previous example where you paid £200 for a £100 gilt if you held them until maturity when they ended you would only get £100 back. Naturally the open market price gets closer to the face value as the end date approaches.

Gilts are issued by the government so the risk of them defaulting on it is very low. Ones offered by companies are called company bonds. These are sometimes indexed linked too (I own some). In this case there is a risk to your capital if the company goes bust. As a result the yields tend to be better to compensate.

Linton

New gilts with defined interest rates and maturity dates are initially auctioned by the government at particular times mainly to the large institutions at a face value of £100. Twice a year you get some interest and on maturity you get the face value price increased by inflation.

Most private investors wont buy new gilts from the government, but instead buy them on the secondary market (just like shares). And just like shares gilts change in price depending on market conditions. This means that an index linked gilt with a face value of £100 may only be available at say £103. But of course the buyback price is based on the original £100. So you wont get inflation matching.

For the small investor gilt funds are probably more relevant than directly holding gilts, though gilts could be useful if your investment period ties in with the gilt maturity date. Gilt funds behave differently to individual gilts as they hold gilts with a variety of maturity dates and so dont provide a guaranteed future value.

On technical terms:

Coupon is the interest rate based on the £100 face value. You will see specific gilts described as say 4.5% - this is the coupon.

Yield is the actual interest rate - ie based on the current price rather than £100.

You also see the term Yield to Maturity, this takes into account the interest and the gain/loss that will be made when the gilt is redeemed for £100 (or £100 + estimated inflation).

cisamcgu

Well, I didn't understand bonds either, and after those explanations, I still don't I'm sure it is my inability to understand rather than the quality of the replies. Even the monevator site has failed miserably to educate me ..

phb71

You and me both cisamcgu

Thank you for the replies. A few questions
- why private investors prefer to buy secondary? New gilts seem to be better to accurately predict how much it'll cost you and how much return you can expect if you hold it until maturity
- What does it mean it pays the rate of inflation?
- How does index gilt fund work, holding a collection of gilt with, I imagine, different maturity timing?
- If Yield is like the coupon but with the current price, I've read that you're paid the interest on the face value (the original price) so why do you need to know the yield then?

Examples are welcomed.

Thanks again

EdGasket

Bonds of any sort are bad right now because they are really expensive to buy yet when interest rates start to rise, their capital value will fall meaning you will make a loss. Be careful.
If you want an indexed-linked gilt fund try iShares INXG where the fund charge is 0.25% which isn't too bad though takes a slice of your 1% or so expected return. This too will fall in value if interest rates rise unless inflation is rising faster!

Linton

To buy on the primary market you need to be registered with the Government organisation that does these things. Also I guess there will be a fairly large minimum purchase. Since the sales are auctions you dont get the bond at the face value - you are bidding against large insurance companies etc.

If you buy from the government you can only buy the particular bonds the government is selling at the time whereas on the secondary market you can buy anything you want.

If you buy an inflation linked bond with a face vale of £100, at maturity you will be paid £100+accumulated inflation since the bond was issued. eg if it was a 10 year bond and inflation averaged 3% annually the redemption price will be £100 * 1.03^10 =£134.39.

Yes an index gilt fund will hold a variety of different index gilts bought at different times and with different lifespans.

You need to know the Yield (or Yield to Maturity)if you want to compare bonds with other possible investments, including other bonds. £1000 spent on 3.5% bonds may actually give the same return as £1000 spent on 4% bonds if the market price is lower. In fact you will find that all Yields for a given time to maturity are pretty close independent of initial coupon rate - if they werent everyone would buy the higher return bonds raising the price making the Yield lower.

grey_gym_sock

let's try an example or 2 ...

starting with a conventional (i.e. not index-linked) bond. suppose a bond was issued some years ago, when interest rates were higher, paying 10% interest. so a bond which has a "face value" (a.k.a. nominal value) of £100 (and it may or may not have been sold for exactly £100 initially, but usually it was sold for a price quite close to £100) will pay £10 interest per year (probably as £5 every 6 months, since most bonds pay interest twice a year). and on the maturity date (which was specified when the bond was originally sold) it will be repaid, i.e. £100 capital will be paid out (at the same time as the last interest payment).

by definition, this bond has a coupon of 10% - this doesn't change.

suppose the maturity date is now 5 years away. and suppose that to buy £100 face value on the secondary market will cost £125.

so for putting up £125 now, you'll get £10 interest per year, for the next 5 years; and then you'll get only £100 back.

there are at least 2 ways to measure the yield you'll get.

1 is the running yield. this is the interest as a % of the intitial cost: £10 / £125 = 8%

the running yield is all very well, but it ignores the fact that you'll get less capital back (£100) than you put in (£125). a better way to measure the total return you'll get should combine the effects of the running yield and the capital loss into a single figure. this is what the redemption yield (sometimes called to yield to maturity, or just the yield) does. this is harder to calculate - try an online calculator such as http://candidmoney.com/calculators/investment-redemption-yield-calculator - and it says the redemption yield in 4.33%.

the redemption yield is generally the best single measure of what you'll get by buying a bond on the secondary market.

though note that it may be worse (or better!) when you consider tax (because the £10 interest per year is taxable, and the £25 capital loss usually doesn't reduce your tax bill at all).

OK, what about index-linked gilts (or other index-linked bonds)?

suppose an index-linked gilt was originally sold with a face value of £100, and it is to pay RPI + 1%, and then be redeemed on a specified date.

this means that all the payments to be made, both interest and the final repayment, will be adjusted for RPI. so 1% interest is initially £1 per year. but suppose that the RPI has doubled since the gilt was issued. in that case, it will currently be paying £2 per year interest. and if it's due to be repaid now, it will be repaid for £200.

but if it isn't due to be repaid yet, the market price could be more or less than £200. if it's less than £200, then by buying now, you'd get more than RPI + 1% assuming you hold the gilt until it's repaid. but if the price is more than £200 (which would be the reality at the moment), you'd get less than RPI + 1%.

but how much less than RPI + 1% would you get if, say, you paid £250 for the gilt, and if it will be repaid after another 5 years? actually - unlike for a conventional gilt - we don't know! because the answer depends on what RPI will do over the next 5 years. though it is possible to do calculations for questions such as: supposing RPI rises at a steady 3% over the next 5 years, then what will the real redemption yield (i.e. the yield relative to RPI) be?

the answer to that question for actual index-linked gilts is in the "yield" column of this table: http://www.fixedincomeinvestor.co.uk/x/bondtable.html?groupid=3530 - and they are all negative figures, i.e. the total return will be less than RPI.

index-linked gilts do look very unattractive at current prices (unless you happen to be a pension fund with index-linked liabilities, which can be "matched" by holding index-linked gilts).

many other bonds look more attractive. it's too simplistic to say they will all fall when (or if) interest rates rise. a bond which has 10 years until it matures will fall if expected interest rates over than next 10 years rise. but supposing base rate rises by 1%, will markets suddenly revise their expectations for interest rates over the whole of the next 10 years up by 1%? probably not; because they are already expecting rates to rise at some point; the first rise coming (say) a year earlier than they expected may not change their expectations for the rest of the 10 years. a longer-term bond (e.g. 30 years) could potentially fall by more than a 10-year bond; but that depends on interest expectations over 30 years; how much effect would 1 rate rise really have on that? it is easy to over-state the risks that a rate rise pose to bond prices. and the rate rise may not happen, anyway.

(i hold various corporate bonds, averaging about 5 years to maturity.)

phb71

Thank you for the replies!

I suppose RPI is the face value?

I thought gilts were much more safe and easy to setup in your portfolio but it seems quite complex actually. Is the Yield influenced by the market? Can it go up and down while you hold your bond until maturity and thus, changing your return? Are you able to know from the moment you buy your bond exactly how much you'll get back by calculating the redemption yield or can this return change?

FInally, how does gilt fund works? Does it behave like shares? How does it work with no maturity date?

Reaper

phb71 wrote: »

I suppose RPI is the face value?

The face value is what proposed original purchase price. It has little relevance after that except when working out how much is pays out e.g if it pays 1% above RPI each year then it will pay out:
Face value * (RPI + 1)%
and of course at maturity when the original face value is repaid and the gilt stops paying out.

I thought gilts were much more safe and easy to setup in your portfolio

It is a common mistake to believe fixed interest products are safe. The return you are getting may not look so good in the future depending on what other investments are offering at the time. Worse if they do look bad then the amount you get back when you try to sell will be less than you paid for it. Or the opposite if you get lucky of course.

Is the Yield influenced by the market? Can it go up and down while you hold your bond until maturity and thus, changing your return?

On a normal gilt or company bond the answer is no. You get the yield on offer through to maturity since it depends on the purchase price. However in the case of index linked it will change over time as inflation rises or falls.

Are you able to know from the moment you buy your bond exactly how much you'll get back by calculating the redemption yield or can this return change?

See above, but yes for a non-inflation linked bond. But only if you hold to maturity as you know how much you will get back. If you sell earlier you will get more or less for it on the open market which means the effective return you got over the term will be affected.

FInally, how does gilt fund works? Does it behave like shares? How does it work with no maturity date?

Yes similar to share funds. They have a big pool of bonds and keep buying and selling them. They may hold to maturity or they may not, it's up to them.

Finally be aware gilts may offer poor value. Pensions funds etc looking to store their money somewhere safe often buy gilts and at times have even driven the yields negative. In other words instead of receiving a return they are actually paying the government to take their money! Madness but in their view it can be a safe harbour when the markets are in turmoil. As a result the price you can get them for is likely to be high resulting in a poor yield.