Explain Gilts/Bonds to me like I am 5 years old please?

SVaz

What is the break even point on conventional vs IL Gilts?
I priced up both for my ladder and the IL Gilts were over 50% more than the conventional with tiny coupons. 

I thought that 50% difference would be better off left invested and would probably double in the same timeframe but then I’m not relying on income from that Sipp once I’m 67. 

QrizB

SVaz said:

What is the break even point on conventional vs IL Gilts?

If you believe in efficient markets, conventional gilts and IL gilts have the same value.

SVaz said:

I priced up both for my ladder and the IL Gilts were over 50% more than the conventional with tiny coupons. 

Are you cetain you were comparing like-with-like?

What rate of inflaton did you assume for your conventional gilt ladder? Or was it simply in nominal terms?

It's easy to model a nominal (0% inflation) ladder with conventional gilts, and an IL one with IL gilts, but the outcomes are not the same.

SnowMan

SVaz said:

What is the break even point on conventional vs IL Gilts?
I priced up both for my ladder and the IL Gilts were over 50% more than the conventional with tiny coupons. 

I thought that 50% difference would be better off left invested and would probably double in the same timeframe but then I’m not relying on income from that Sipp once I’m 67. 

Scroll down to the UK instantaneous implied inflation forward curve (gilts) at

https://www.bankofengland.co.uk/statistics/yield-curves

Instantaneous is the implied inflation at that specific point in time. So for a 20 year gilt, for example, it's roughly an average of the brown curve from time 0 years through to time 20 years (ignoring that in practice that coupon payments may effectively shorten the term of the gilt)

MetaPhysical

Just sanity checking, if holding the gilts in a SIPP for diversification are we really holding them for income or to protect our capital from a crash?  Where does the needle point to between the two?

SVaz

Bit of both I would say.

I’ve got a long way to go in understanding IL Gilts. 
Am I right to assume that buying them at or below face value is the only sensible way to go?

People who bought them well over face value with little coupons would lose out even if held to maturity, wouldn’t they?  Even with high inflation? 

If inflation eats away at my conventionals over the next decade, at least I bought two of them under par so will have a £600 capital gain over and above the coupons, even after paying slightly over for the other two. 

If I’ve misunderstood entirely then at least I’ve only cocked it up in a relatively small way. 

GenX0212

MetaPhysical said:

Just sanity checking, if holding the gilts in a SIPP for diversification are we really holding them for income or to protect our capital from a crash?  Where does the needle point to between the two?

I would say it probably depends on whether they are index linked or not and whether intending to hold to maturity?
If buying index linked with the intent to hold to maturity then you are aiming to guarantee that the £100 in your pocket keeps pace with inflation and retains the same spending power several years later. You get a small coupon return each year as a small extra incentive.

With standard gilts you might get a higher annual coupon each year as income or else you are hoping that when you sell them (or they mature) that the value they return exceeds what you you paid for them in real terms.

I think sometimes it's easy to look at interest rates and think "I'm making money" but unless you are outpacing inflation then in reality your capital is slowly eroding over time. Think how much weekly shopping you could get for £100 ten years ago versus today and then imagine what you might be able to get for £100 in another ten years time.
It's the same if people look at their pot after a year of withdrawals and say they haven't actually spent any of their pot because of growth, the headline figure might be the same, or even higher, but unless you adjust for inflation then you might be fooling yourself.

QrizB

SVaz said:

Bit of both I would say.

OK, let's look at an example.

Imagine you want one payout of £10k in October 2035 and use the Gilt Ladder tool, without adjusting any of the other parameters.

It suggests you buy £6622 of TG35. The total payout icluding coupons over the period is £10000; the final redemption payment of £9411.76 of 2035 money.

Now change that to an index-linked gilt.

It now suggests you buy £8858 of TR35. The total payout is still £10000 but that's in today's terms; the final payout of £9113.23 is in 2025 money.

If inflation runs at the BoE target of 2%pa for the next ten years, one 2025 pound will be worth £1.22 in 2035. So the "£9113.23 in 2025 money" you get from selling TR35 will actually be £11118.

SnowMan

SVaz said:

Am I right to assume that buying them at or below face value is the only sensible way to go?

People who bought them well over face value with little coupons would lose out even if held to maturity, wouldn’t they?  Even with high inflation?  

If an index linked gilt has a clean price of exactly £100 ('par' in the jargon) it just means that the real yield (gross redemption yield) is equal to the coupon, because in purchasing that gilt you would get your money back plus inflation at maturity, and on top would have the annual coupon.

T38, which has a 1.75% coupon, had a clean price of 99.38 at yesterday's close and the calculated real yield was 1.80%. So the real yield was slightly above 1.75% because it is priced at marginally below par. If the price went up to 100 the real yield would reduce to about 1.75% i.e the coupon.

T32 (1.25% coupon) is priced at 101.014 at yesterday's close which results in a calculated real yield of 1.1%. The fact that it is priced above par is not a reason not to buy it. Requiring a real yield above 1.1% would be a reason not to buy it.

In practice most index linked gilts have a low coupon as the coupon is usually set at issue to be about the real yield at issue so that they can be initially priced around par. So generally most index linked gilts are (clean) priced below par currently as real yields are generally above zero and above the low coupon rates. 

GenX0212

SnowMan said:

SVaz said:

Am I right to assume that buying them at or below face value is the only sensible way to go?

People who bought them well over face value with little coupons would lose out even if held to maturity, wouldn’t they?  Even with high inflation?  

If an index linked gilt has a clean price of exactly £100 ('par' in the jargon) it just means that the real yield (gross redemption yield) is equal to the coupon, because in purchasing that gilt you would get your money back plus inflation at maturity, and on top would have the annual coupon.

T38, which has a 1.75% coupon, had a clean price of 99.38 at yesterday's close and the calculated real yield was 1.80%. So the real yield was slightly above 1.75% because it is priced at marginally below par. If the price went up to 100 the real yield would reduce to about 1.75% i.e the coupon.

T32 (1.25% coupon) is priced at 101.014 at yesterday's close which results in a calculated real yield of 1.1%. The fact that it is priced above par is not a reason not to buy it. Requiring a real yield above 1.1% would be a reason not to buy it.

In practice most index linked gilts have a low coupon as the coupon is usually set at issue to be about the real yield at issue so that they can be initially priced around par. So generally most index linked gilts are (clean) priced below par currently as real yields are generally above zero and above the low coupon rates. 

Worth adding that with something like T30I the price of £340+ reflects the inflation indexation that has already been applied, because in this case the original £100 was issued in year 2000

SnowMan

GenX0212 said:

SnowMan said:

SVaz said:

Am I right to assume that buying them at or below face value is the only sensible way to go?

People who bought them well over face value with little coupons would lose out even if held to maturity, wouldn’t they?  Even with high inflation?  

If an index linked gilt has a clean price of exactly £100 ('par' in the jargon) it just means that the real yield (gross redemption yield) is equal to the coupon, because in purchasing that gilt you would get your money back plus inflation at maturity, and on top would have the annual coupon.

T38, which has a 1.75% coupon, had a clean price of 99.38 at yesterday's close and the calculated real yield was 1.80%. So the real yield was slightly above 1.75% because it is priced at marginally below par. If the price went up to 100 the real yield would reduce to about 1.75% i.e the coupon.

T32 (1.25% coupon) is priced at 101.014 at yesterday's close which results in a calculated real yield of 1.1%. The fact that it is priced above par is not a reason not to buy it. Requiring a real yield above 1.1% would be a reason not to buy it.

In practice most index linked gilts have a low coupon as the coupon is usually set at issue to be about the real yield at issue so that they can be initially priced around par. So generally most index linked gilts are (clean) priced below par currently as real yields are generally above zero and above the low coupon rates. 

Worth adding that with something like T30I the price of £340+ reflects the inflation indexation that has already been applied, because in this case the original £100 was issued in year 2000

Yes that's one of the two 8 month lagged index linked gilts that still exists (along with T2IL). It was actually issued in June 1992 so the indexation was from then (with an 8 month lag). As you say there is no clean price for those two index linked gilts just the price including indexation to date. 

Those two index linked gilts are best avoided in my view. I understand amongst other things the spreads on those are quite high because there is limited trading going on in them.