With official interest rates spiralling higher as the Bank of England grapples with inflation, yields across fixed income markets have also exploded higher. This provides investors with a chance to earn a decent rate of return.

This article explains what gilts are, how they work, the potential returns on offer and different ways to buy them.

WHAT IS THE DIFFERENCE BETWEEN GOVERNMENT AND CORPORATE BONDS?

Broadly, there are two types of bonds, sovereign and corporate. UK sovereign or government bonds are a type of IOU issued by the government’s debt management office to fund government expenditures. UK government bonds are also called gilt-edged securities or gilts for short.

Corporate bonds are issued by companies such as supermarket Sainsbury’s (SBRY) to fund investment in the business or for general corporate purposes.

Investing in a bond is effectively lending money to a company or government until a specified date – known as the maturity or redemption date. The company or government is the ‘issuer’ of a bond.

In return for buying a bond (and lending money to a company or government), an interest payment is made by the issuer. This is typically known as a coupon and is usually paid once or twice a year, depending on the type of bond.

At maturity the investor also receives back the original issue price of the bond unless the issuer defaults on its debts.

It is worth remembering that bond yields move in the opposite direction to bond prices. With gilt yields moving higher over the last year-and-a-half bond prices have been moving lower.

For example, the two-year gilt has a yield of 5.1% compared with a negative yield in December 2021 just before the Bank of England starting its rate hiking cycle.

Because the two-year gilt was issued when official rates were much lower it can be purchased today for just over £92 compared with its
£100 issue price. That is unwelcome news for investors who purchased at issue, but good news for future buyers who have the chance to lock-in a capital gain.

When the gilt matures on 7 June 2025 investors will receive £100, creating eight percentage points of capital gain. It is convention to quote a gilt’s redemption yield which reflects capital gains/losses at maturity in addition to interest payments.

Gilts had a negative yield in December 2021. This means investors were locking in a guaranteed loss had they held to maturity because the interest payments were worth less than the capital loss incurred at maturity.

Many investors this year have been taking advantage of low gilt prices to lock in expected future capital gains.

A tax efficient account such as an ISA or SIPP which are sheltered from capital gains and income taxes can be a good vehicle for holding a gilt.

HOW TO JUDGE RISK AND RETURN

It is worth pointing out that higher returns come with higher risks.

While money in bank savings accounts is guaranteed up to £85,000, there are no such guarantees for bonds. However, UK government bonds are as close to being risk-free as an investor can achieve.

Unlike some savings accounts where money is tied-up for specific periods, called time deposits, investing in government bonds doesn’t come with such restrictions.

Investors are free to sell bonds in the market at any time and they do not have to be held to maturity, although dealing spreads, commissions and platform fees need to be considered.

At the time of writing two-year gilts have a yield to maturity of 5.1% and 10-year gilts yield 4.4%, levels which have not been seen in decades.

Gilts represent a risk-free rate because it is unlikely that the UK government will not continue paying interest on its debts and repay the principle on maturity.

That is not true of all countries and in several emerging sovereign debt markets there have been defaults in recent history.

The risk of investing in gilts is very low compared with investing in corporate bonds or stocks and shares. It is worth reflecting on the current yields on offer despite risks the Bank of England continues to increase interest rates.

Locking in 4% to 5% risk-free may look attractive to some investors in this context. Also remember, government bonds typically provide safety during choppy markets and economic recessions, providing ballast to diversified portfolios.

BOND JARGON BUSTER

It is worth familiarising yourself with some bond jargon. A clean bond price excludes accrued interest between what are typically bi-annual coupon payments. A dirty bond price includes this accrued interest and is the price you will actually pay. 

Let’s assume a bond priced at £100 pays a 3% coupon in two separate payments across a year – so £1.50 apiece. The accrued interest per day over that six-month period is 0.82p. If the coupon is paid at the beginning of March and the bond is purchased on 30 April (61 days later) then the accrued interest would be roughly 50p.

At issue or on the coupon paid date the clean and the dirty price will be the same.

A running yield is the coupon multiplied by the face value divided by clean price. For example, a bond priced at £95, with a 3% coupon, maturing in three years, has a running yield of 3.16% [(3% x £100) / £95 = 3.16%].

The running yield doesn’t tell you what you might earn if you hold a gilt to maturity. For that you need to calculate the redemption yield which also factors in capital gains/losses.

You usually need a spreadsheet to make an accurate calculation but there is a simple short cut which adjusts the running yield to reflect
the difference in the price from the face value of the bond.

Redemption yield is calculated by adding the running yield to the implied gain divided by the years to maturity, multiplied by 100.

Using the above example again, it would be 3.16% + [(5/3) x 100] = 4.91%.

The short cut works for shorter duration issues while a spreadsheet is needed for longer duration gilts.

Bond duration measures the sensitivity of a gilt to a 1% move in interest rates. The price of bonds with longer to run until maturity will be more sensitive to changes in interest rates, particularly if the coupon is relatively low.

The highest duration will be found with long-dated bonds with lower coupons, and the lowest duration in shorter-dated bonds with higher coupons.

INFLATION-PROTECTED BONDS

Index-linked gilts have pay-outs linked to the rate of UK inflation, measure by the retail price index.

The regular coupon and the amount you get back at maturity is adjusted for inflation, instead of being a fixed amount – as with conventional gilts.

Index-linked bonds tend to have longer maturities than conventional bonds. So, their price can be more sensitive to changes in interest rates than conventional gilts.

HOW TO INVEST IN GOVERNMENT BONDS

Investing in specific gilts is an option for investors with the confidence and knowledge to pick the most attractive parts of the gilts market.

While there isn’t a huge risk of not getting the principle back, that is not the same thing as not losing money. Think back to the negative implied yields in 2021, for example.

Picking the ‘right’ part of the yield curve can be tricky and requires a ‘correct’ view on the future path of official interest rates, inflation, and growth in the economy.

Investors can trade individual gilts on most investment platforms via the phone. The cost is typically the same as trading individual shares.

It is always worth bearing in mind that although there are no minimum trading sizes, smaller value trades may not make economic sense. For example, buying £50 worth of the two-year gilt means losing 20% in dealing charges if the cost is around £10 a trade.

Investing in individual gilts may not be for everyone and there are several passive and active fund options available. The cheapest and most straightforward to gain exposure to gilts is through exchange-traded funds – with several shown in the table.

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