What are gilts?
Gilts are bonds issued by the UK government to fund public spending. When you buy a gilt, you're essentially lending your money to the government, which promises to repay the amount after a specified term. The government also makes regular interest payments until the loan is repaid.
In the simplest terms, a gilt can be seen as both a loan from you, the investor, and an IOU from the government.
The UK Debt Management Office (DMO) is the government agency responsible for issuing gilts on behalf of HM Treasury.
Keep in mind that the value of investments can go down as well as up, so you could get back less than you invested.
The gilt-edged jargon buster
This guide aims to keep the language simple, but the gilt market has its own terminology you may come across elsewhere:
- Gilts – Government-issued bonds, offered to fund public spending
- The holder – The investor who buys the gilt
- Principal – Face value of the gilt
- Maturity date – The date the face value is due to be paid back
- Coupon – The fixed interest payment
- Coupon rate – The fixed interest payment rate
- Redemption yield (sometime gross redemption yield) – The return on capital that the investor will receive from buying the gilt and holding it to maturity
- Running yield – The current income return for a gilt
How do gilts work?
Gilts are securities: a tradeable financial asset. As a specific type of bond, they form part of one of the main asset classes, alongside shares and property. The name gilt comes from 'gilt-edged security', reflecting the fact that the government has never failed to make interest payments or repay the face value.
The relative safety of gilts makes them a low-risk, low-reward investment, but their stability means they could have a place in a balanced and diversified investment portfolio.
There are two types of gilt, the conventional gilt and the index-linked gilt.
What is a conventional gilt?
The conventional gilt is the most common type of government bond, making up around 75% of the gilt market. Each gilt will have a face value of £100, an interest rate, and a maturity date on which the face value will be repaid.
When you buy a gilt, you'll receive an interest payment usually twice a year until the gilt matures.
Conventional gilts are fixed-income securities, as the interest payments and the face value don't change from issue to maturity.
If you bought a single unit at issue with an annual interest rate of 3.5%, you'd expect to receive £1.75 every six months, giving you an annual income of £3.50 per year (3.5% of £100). If it had a ten-year maturity, this would amount to a total income of £35 over the term.
What is an index-linked gilt?
Although it shares the same characteristics as a conventional gilt (£100 face value at issue, annual interest payment, and maturity date), the index-linked gilt differs in that it's not a fixed-income bond. Nor is there a guarantee that the original face value will be repaid at maturity.
Instead, the regular payments and the final repayment are linked to the Retail Prices Index (RPI), so they can rise or fall in line with UK inflation. This makes calculating returns less straightforward than with conventional gilts.
However, with an illustrative example it's possible to show how inflation might affect the face value and interest payments.
Illustrative example of inflationary effect on an index-linked gilt
You buy a single unit at issue, with a face value of £100 and an interest rate of 0.125%. Because they are linked to the RPI, index-linked gilts tend to have a much lower interest rate than conventional gilts.
If inflation rose by 3% in the first year, the interest payment for that first year would be £0.13. More importantly, the face value would've increased to £103, which is where £0.13 interest payment comes from: 0.125% of £103 rounded to the nearest penny.
If the index-linked gilt had a ten-year term, and inflation averaged 3% over that term, the face value at maturity would be £134.39, with total income over the term at around £1.48.
So, although the interest rate remains fixed at 0.125% throughout, the interest payments increase in line with the inflation-adjusted face value.
This example is summarised in the table below:
| Year | Inflation-adjusted face value | Annual interest payment (0.125%) |
|---|---|---|
| 1 | £103.00 | £0.13 |
| 5 | £115.93 | £0.15 |
| 10 | £134.39 | £0.17 |
Based on a single gilt issued with £100 face value, 0.125% interest rate, and average inflation of 3%.
The example and table are for illustrative purposes only and do not reflect actual or expected inflation over a ten-year period.
How do interest rates affect gilt prices?
Although gilts are issued with a face value of £100, remaining fixed for conventional gilts, their trading prices can rise or fall.
This is largely influenced by market interest rates, which move in line with the Bank of England base rate. When interest rates rise, gilt prices tend to fall, and when rates fall, gilt prices tend to rise.
The relationship between gilts and interest rates, at a glance
When interest rates rise:
- The Bank of England increases the base interest rate, leading to higher interest rates across the board
- New gilts are issued offering higher interest rates
- Existing gilts become less attractive because of lower interest payments compared to newer gilts
- Holders lower the market price of existing gilts to make them a more competitive choice for buyers.
When interest rates fall:
- The Bank of England decreases the base interest rate, leading to lower interest rates across the board
- Existing gilts become more attractive because of their higher interest payments compared to newer gilts with a lower rate of interest
- Holders can raise the market price of existing gilts, knowing investors will be willing to pay more for them.
This relationship between gilts and interest rates applies to both conventional and index-linked gilts. However, because the interest payments and face value of index-linked gilts are adjusted in line with the Retail Price Index (RPI), their market prices are also influenced by inflation expectations.
How do you compare gilts?
Investors and fund managers can use different factors to assess a gilt's appeal. Primary among these is the redemption yield (sometimes shown as gross redemption yield (GRY)) and the running yield. These will give you an income relative to the market price and the total return if the gilt is held to maturity.
The same factors apply to Index-linked gilts, but with the added complication of calculating future payments dependent upon inflation.
What is the redemption yield when comparing gilts?
The redemption yield is used to work out what the total annual return of a gilt might be if held until maturity. Investors and fund managers consider the purchase price and interest payments, as well as the repayment of the face value.
Capital gain or loss, along with the time value of money (TVM) are also considered.
- Capital gain or loss – whether there is a gain or a loss to be made from buying a gilt at a price different from its face value.
- The time value of money – the idea that a sum of money is worth more today than the same amount in the future, because inflation reduces its purchasing power.
What is the running yield when comparing gilts?
With government bonds, and bonds in general, the running yield is the current income earned over the year, based on the current market price (not the face value).
Annual interest payment ÷ current market price x 100
If a gilt had an annual interest payment of £4.25 (based on an interest rate of 4.25% on a £100 face value), and a current market price of £112, the formula would look like this:
4.25 ÷ 112 x 100 = 3.79
The running yield would be 3.79%. If you were to buy the gilt, over the year you would earn 3.79% of what you paid for it.
Can you lose money on a gilt?
As with any investment, it's possible to lose money on a gilt. There are a few ways this might happen, such as:
- Rising interest rates – If interest rates are rising, gilt prices tend to fall. So, if you sell on the secondary market for a lower price than you paid, you will make a capital loss.
- Paying more than the face value - If you bought a conventional gilt when interest rates were low and paid above the face value, when it matures you'll only be repaid its £100 face value. The difference may exceed the income you received, resulting in capital loss.
- Inflation risk – Inflation can lead to losses for both types of gilt. For conventional gilts, rising inflation reduces the real value of both the interest payments and the face value at maturity. For index-linked gilts, deflation (falling prices) can reduce the actual value of interest payments and the amount repaid at maturity.
However, if interest rates and inflation remain stable over a gilt's term, you're likely to get back the face value and amount of interest you expected when bought.
How can you buy gilts?
Gilts are issued and sold at auction by the Debt Management Office (DMO). Only specialist institutions, known as Gilt-Edged Market Makers (GEMMs) are allowed to bid on what is known as the primary market. They then go on to sell the gilts on the secondary market to banks, investment and pension funds, brokers and private investors.
As an individual investor, you can buy and sell gilts on the secondary market via the London Stock Exchange's gilt-edged market. This is usually done through a broker or a trading platform.
The low risk factor associated with gilts is reflected in the lower returns, which is why gilts are usually bought in bulk. Other ways you can invest in gilts include:
- Investment funds – diversified funds such as unit trusts or with profits, which may hold gilts alongside higher risk assets
- Bond or gilt-specific ETFs (Exchange Traded Funds) – funds that hold a mix of bonds and gilts, or just gilts, that can be traded on the stock exchange like company shares
- Investment platforms – online services that allow private investors to trade gilts, bonds and other assets.
What are the differences between corporate and government bonds?
| Gilts (Government bonds) | Corporate bonds | |
|---|---|---|
| Issuer | Gilts are issued by the UK government | Corporate bonds are issued by companies |
| Risk | Gilts are considered low risk, as they are government backed and there is minimal risk of defaulting | Corporate bonds carry a higher risk than gilts due to there being more of a chance of default. Risk is generally based on the company's financial strength |
| Returns | They offer lower returns because of the low risk | There are often higher interest rates to make the bond more attractive and to compensate for the higher risk |
| Credit rating | A high credit rating due to the government never having failed to make interest payments or repay the face value | Credit ratings vary depending on the company and its creditworthiness |
| Market liquidity | Gilts are widely traded and bought and sold with ease | Corporate bonds may be harder to sell, particularly those from smaller companies |
| Purpose | Money raised from the primary sale of gilts is used to fund public spending | The money raised from the sale of corporate bonds is used to fund business activities |