Index Link Gilt

Linton

Reaper wrote: »

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.

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.

....

A couple of clarifications. The annual interest on an index linked gilt is the coupon multiplied by the face value. But the face value increases by inflation. So if you bought a 1% index linked bond at £100 and in the first year inflation was 3% for the next year the face value would be £103 and the interest 1%*£103, not 1%+3%=4%.

As to risk, they key point about gilts is that they are much less volatile than shares since the current value of a gilt can be calculated mathematically from its coupon, the maturity date, and prevailing interest rates. This is unlike a share whose intrinsic value is unclear and whose market price can vary wildly from day to day because of market sentiment.

Over the longer term broadly based share funds can fall by say 40% in the event of major economic downturns. Gilt funds wont fall to anything like the same extent. Furthermore, and this is traditionally why investors bought gilts, when share prices rise gilts tend to fall and vice versa. So gilts help a portfolio's diversification.

Gilts are also less risky in the sense of becoming valueless. If a company goes bust its shares can be worthless, whereas a gilt is guaranteed by the UK government. It would need a catastrophic economic collapse for the UK to fail to honour gilts, this has never happened in the past. Of course some other countries have defaulted. Government bonds from risky countries can give you much better returns than UK gilts - Greek Government bonds for example. However you are then taking a much greater risk of loss.

EdGasket

"Gilts are less risky" - a bit of an over-simplification. If you buy a typical gilt at the moment you will pay a premium because interest rates are low. For instance to buy £100 worth of 4.75% 2030 treasury gilt, will cost you over £134 so even if interest rates remain at 0.5% you would lose £34 of capital over the life of the bond. If interest rates rise, the price of the gilt could easily fall sub £100 meaning if you cashed-in you could lose more than £34 on your £134 investment. I'd say gilts are very risky right now because they are over-valued by historical measures.

grey_gym_sock

EdGasket wrote: »

"Gilts are less risky" - a bit of an over-simplification. If you buy a typical gilt at the moment you will pay a premium because interest rates are low. For instance to buy £100 worth of 4.75% 2030 treasury gilt, will cost you over £134 so even if interest rates remain at 0.5% you would lose £34 of capital over the life of the bond. If interest rates rise, the price of the gilt could easily fall sub £100 meaning if you cashed-in you could lose more than £34 on your £134 investment. I'd say gilts are very risky right now because they are over-valued by historical measures.

if you buy that gilt, and hold it until it matures in 2030, you know that you'll get a redemption yield of 2.1% - for the redemption yields of conventional gilts, see the last column of this table: http://www.fixedincomeinvestor.co.uk/x/bondtable.html?groupid=3

where's the risk in that?

well, "inflation" is the correct answer. we don't know what it will be over the next 15 years. after allowing for inflation, your real return could be positive or negative. we do know that 2% is the target inflation rate, and the bank of england is seriously undershooting the target now; but 15 years is a long time.

if you don't hold the gilt till maturity, then you don't know what your return will be. however, if you look at the yields in the last link, you'll see that they are generally lower for shorter-term gilts, higher for longer-term gilts. and that is how it usually looks. if you assume that the yield curve will remain the same, i.e. that a 15-year gilt will continue to have a yield of about 2.1%, and that a 10-year gilt will continue to have a yield of about 1.6%, and so on, then by buying the 15-year gilt now and selling it after 5 years (when it's become a 10-year gilt), you'll get a return of more than 2.1% - more like (without actually doing the calculation) 3% . after selling your (now) 10-year gilt, you might use the proceeds to buy another 15-year gilt, and try to do the same thing again. of course, gilt prices may have changed after 5 years in such a way that this doesn't work; but in the worst case you can just hold on to your original gilt until it matures and pick up 2.1% return.

so i think it's beside the point to say that the price of the gilt could fall to less than 100. because you wouldn't be selling it then. you would only be selling if there is an opportunity to "roll" into a longer-term gilt. if there's no suitable opportunity, you'd just hold on for your 2.1% return.

now what about that assumption that the yield curve will remain the same? of course, it's very unlikely to remain the same. it could do any number of things. yields could rise or fall. but i think that remaining the same is a good baseline assumption - i.e. it could easily be wrong in either direction.

i don't think it's valid to expect yields to rise just because they are historically low. because you are comparing with periods when inflation was higher, growth was higher, etc. and it is unlikely that macroeconomy conditions will revert to those of previous decades (even if jeremy corbyn becomes prime minister ).

and note that "rolling" bonds may work even if yields do rise. it depends on the shape of the yield curve.

now you may not be impressed with a guaranteed return of 2.1%, with the possibility of turning it into about 3% . 1 way to push for a bit more return is to use corporate bonds in place of gilts (which is what i'm doing).

but apart from bonds, what are the alternatives? do equities look more attractive? (i do have plenty in equities, as well as bonds.) cash? it pays almost nothing, so holding cash will only work if there is going to be a better opportunity to buy into equities or bonds, and if you take the plunge at (more or less) the right time. and what if we're stuck in a low-return environment (from both equities and bonds)? - because then there may never be the kind of opportunity you're waiting for.

Reaper

Linton wrote: »

The annual interest on an index linked gilt is the coupon multiplied by the face value. But the face value increases by inflation.

Ah yes, I had forgotten that. Thanks.

EdGasket

OK grey gym sock you obviously understand gilts but the OP doesn't; the reply was aimed at the OP. Who knows if the OP assumes gilts are safe and that he can cash his gilt in at ANY time without loss? He might not be aware that his gilt would lose value towards maturity by over 30%, those are valid risks to be aware of.

coyrls

grey_gym_sock wrote: »

but apart from bonds, what are the alternatives? do equities look more attractive? (i do have plenty in equities, as well as bonds.) cash? it pays almost nothing, so holding cash will only work if there is going to be a better opportunity to buy into equities or bonds, and if you take the plunge at (more or less) the right time. and what if we're stuck in a low-return environment (from both equities and bonds)? - because then there may never be the kind of opportunity you're waiting for.

The return of bonds is often compared to money market rates but retail investors have other options, for example fixed term savings (now at 3% for 5 years) provide security (if you keep below the FSCS Protection Limit for each institution) and a better return than gilts. You could even construct a fixed term savings "ladder" to benefit from rising interest rates. P2P lending is a higher risk, higher return option with bond like characteristics.

phb71

Thank you for all the infos. I'm getting there!

So for A) conventional gilts and gilt funds, what are the calculations and due diligence you need to do to decide to 1) buy this specific gilt/fund at that time 2) sell it before the maturity date.

Also:
- Is the yield to maturity the same as redemption yield?
- what influence the face value of a gilt to be higher/lower vs the par?
- what influence the coupon to be high/low in the market?

Reaper

phb71 wrote: »

- Is the yield to maturity the same as redemption yield?

Yes

phb71 wrote: »

- what influence the face value of a gilt to be higher/lower vs the par?
- what influence the coupon to be high/low in the market?

What competing investments are offering and what people expect them to offer in the future. If I am getting 2% in my building society account a 5% bond yield looks attractive. If I am getting 10% then I am unlikely to be interested. However if I think the building society rate will rise or fall in future then I may take a different view of that bond.

As a result of this people are willing to pay more or less than the face value, and in doing so get more or less yield than the officially stated rate.

phb71 wrote: »

So for A) conventional gilts and gilt funds, what are the calculations and due diligence you need to do to decide to 1) buy this specific gilt/fund at that time 2) sell it before the maturity date.

As above, what you think the market will do. Also what you think inflation will do. If your gilts are index linked they will get more popular (and therefore rise in price) if inflation takes off or if people think it will soon. If not indexed linked the reverse is true as fixed rates look bad in times of high inflation.

phb71

OK - and if I hold a gilt for a few years - can the coupon changed based on the rise/fall of overall interest rate over the years and actually change my return from year 3 vs years 4 for example despite that I already hold the gilt?

In the same mindset, if I bought gilts £120 with a nominal value of £100 - if I sell it:
- before the maturity date, can the price be higher or lower than £120 based on the market just like shares?
- on the maturity date, I will get back £100 in any case?

So what keep everyone to look for gilt with an initial price as small as possible (under the nominal value) and a coupon or running yield as high as possible and just ignore all the others (price above nominal value, low coupon/yield).?

Reaper

I think all of these questions have been covered already above.

phb71 wrote: »

OK - and if I hold a gilt for a few years - can the coupon changed based on the rise/fall of overall interest rate over the years and actually change my return from year 3 vs years 4 for example despite that I already hold the gilt?

Are you talking index linked? If not everything remains fixed for the duration of the term. For index linked the face value changes with inflation and as the yield is a percentage of that figure the payout changes with inflation too.

In the same mindset, if I bought gilts £120 with a nominal value of £100 - if I sell it:
- before the maturity date, can the price be higher or lower than £120 based on the market just like shares?
- on the maturity date, I will get back £100 in any case?

For non-index linked yes and yes

So what keep everyone to look for gilt with an initial price as small as possible (under the nominal value) and a coupon or running yield as high as possible and just ignore all the others (price above nominal value, low coupon/yield).?

Pretty much. But the price above nominal value becomes more important as the redemption date looms. The price of the gilt will start to move towards it as the date approaches.