Learning about Gilts

[TheMotorcycleBoy]

Hi all,

As some of you will probably already know myself and Matt have started to dabble in equities and bonds in order to grow a portfolio for eventual! retirement (along with pension etc.) After researching GB corporate bonds we are now looking at Gilts/UK govt. securities. Before trying to study concepts such as "yield curves", we thought it would be an idea just to look at a very small selection of those available, for educational purposes.

So looking on the HL and the fixedincomeinvestor sites, we found these 3 which all mature in 2022:

Treasury 4% 2022 (TR22)
http://www.hl.co.uk/shares/shares-searc ... 70322-gilt
https://www.fixedincomeinvestor.co.uk/x ... &groupid=3

Treasury 0.5% GILT 22/07/22 GBP1 (TY22)
http://www.hl.co.uk/shares/shares-searc ... 20722-gbp1
https://www.fixedincomeinvestor.co.uk/x ... &groupid=3

Treasury 1.75% 2022 (TG22)
http://www.hl.co.uk/shares/shares-searc ... -1.75-2022
https://www.fixedincomeinvestor.co.uk/x ... &groupid=3

Firstly the terminology: Are they all known as "Gilts", and what (if any) is the significance of the second letter (the R, Y, G etc) in their short description?

Secondly the figures: Whilst the listing "redemption yields" (I'm guessing this is effectively the same as YTM) from the HL site, are very close to one another (when I looked the variance was 0.96%-1.06%), the coupon values varied a lot. Since I couldn't find information on their issue dates, would I be right to guess, that those with higher coupon rates are the long-dated bonds, i.e. in terms of time since issue TR22 > TG22 > TY22 ?

thanks Mel

[Alaric]

They all mature in the same year 2022. The description TG22 etc is to give them a unique code. The coupons are different because the cost of borrowing for the UK government has changed and reduced over recent years. You should find that the ones with higher coupons have higher prices. They would all have originally been issued at or around par. (100).

[Alaric]

Since I couldn't find information on their issue dates, would I be right to guess, that those with higher coupon rates are the long-dated bonds, i.e. in terms of time since issue TR22 > TG22 > TY22 ?

It's likely that the higher coupon bonds are the ones that have been issued the longest. That's not what the term "long-dated" is taken to mean. In the context of the market in Gilts and other fixed income investments, you measure from today. Thus a bond maturing in 2022 is now a "short" no matter whether it was first issued last month or decades ago.

[GoSeigen]

Melanie,

The two replies by Alaric are sound.

Note that gilts will generally be priced by their duration, not maturity. Thus considering two hypothetical gilts with the same maturity date: the gilt with the higher coupon (thus lower duration) would be priced in the market to have a lower YTM than the other. (I suppose tax factors could distort this but I haven't noticed it myself.)

GS

[Alaric]

Thus considering two hypothetical gilts with the same maturity date: the gilt with the higher coupon (thus lower duration) would be priced in the market to have a lower YTM than the other.

I would have expected the shape of the yield curve to have an effect. With strips, the price of each payment can be determined and anomalies priced out. With the contraction of taxed life assurance funds, the majority of market participants would be gross nowadays?

[TheMotorcycleBoy]

It's likely that the higher coupon bonds are the ones that have been issued the longest.

Yup. When the base rate and hence borrowing costs were higher.

That's not what the term "long-dated" is taken to mean. In the context of the market in Gilts and other fixed income investments, you measure from today. Thus a bond maturing in 2022 is now a "short" no matter whether it was first issued last month or decades ago.

Ok, so

long-dated == long time from now till it matures

Note that gilts will generally be priced by their duration, not maturity.

Ok, thanks. So generally lower duration = lower higher price?

Thus considering two hypothetical gilts with the same maturity date: the gilt with the higher coupon (thus lower duration) would be priced in the market to have a lower YTM than the other.

I'll try to figure out later when I have more time, for now I got this data:

TR22 4% 111.7 @ 0.966 MD = 3.641
TY22 0.5% 97.8 @ 1.056 MD = 4.214
TG22 1.75% 103.1 @ 1.055 MD = 4.23

Well yield differences are very small so I guess it's to make accurate comparisons of the above. TR22 lowest duration has lowest yield, but TY22 and TG22 just look too close to really notice much.

Their yields look so small, I'm not that they are worthy of considerations by small-timers like me and Mel.

Matt

[Alaric]

Their yields look so small, I'm not that they are worthy of considerations by small-timers like me and

That's the current risk free rate. What you have to decide is how much risk you want to take of losing some of your investment in search of a higher return. If you buy a bond that stands well above par, you guarantee that you lose value if you hold it to maturity and it's only the coupon that compensates.

[colin]

Note that the yield on new issue gilts is not set by the government, whatever the nominal yield states as the bonds are bought in an auction process so bidders pay whatever they believe them to be worth at the time, so a newly issued 100 pound guilt with 5% coupon can sell for £95 yielding an interest rate of 5.3% if that's what the market is prepared to pay at that time.

[colin]

Their yields look so small, I'm not that they are worthy of considerations by small-timers like me and

Low is an understatement, yields on the index linked market are negative!

You can buy US Treasuries at higher yields Investors usually use government bonds as a risk management tool rather than for the ultimate expected return. But you should have accumulated a small library of books to learn about investment and risk management, this is the basic bread a butter stuff.

[Alaric]

Low is an understatement, yields on the index linked market are negative!

In real terms. In money terms they will deliver something, depending on the rate of inflation as measured by the RPI Index. The something will be lower than the RPI rate though. Recent issues have next to no coupon, so the return is almost exclusively the maturity payment.

[johnhemming]

One risk with Gilts is "sovereign risk" in that there are very few countries that have not at some stage defaulted on government debt in some way. There is a wikipedia list of sovereign defaults
https://en.wikipedia.org/wiki/List_of_s ... ebt_crises

This does have some entries for the UK, but I don't know what they mean.

The UK has not yet properly recovered from the financial crisis of 2007-9ish. Hence you should give consideration to what might happen, for example, post brexit and if Jeremy Corbyn started running state socialist policies and what would happen to government debt. I don't think this applies for debt which matures in 2022, but if you had longer dated debt it might be an issue to consider. It takes time for governments to mess things up.

[colin]

Yes Alaric so from the Linkers market as a whole past returns from coupon payments applied to current capital price has been around 1.8% below RPI, RPI is 2.5% today so should RPI inflation remain the same that projects a nominal return of .7% . Does that sound right?

[GoSeigen]

Thus considering two hypothetical gilts with the same maturity date: the gilt with the higher coupon (thus lower duration) would be priced in the market to have a lower YTM than the other.

I would have expected the shape of the yield curve to have an effect.

Indeed, should have added "... assuming the usual up-sloping yield curve".

GS

[GoSeigen]

Note that gilts will generally be priced by their duration, not maturity.

Ok, thanks. So generally lower duration = lower higher price?

Not price exactly, no. Sorry. When bond people talk about price they generally mean yield! For me, yield is the price of any investment.

Thus considering two hypothetical gilts with the same maturity date: the gilt with the higher coupon (thus lower duration) would be priced in the market to have a lower YTM than the other.

I'll try to figure out later when I have more time, for now I got this data:

TR22 4% 111.7 @ 0.966 MD = 3.641
TY22 0.5% 97.8 @ 1.056 MD = 4.214
TG22 1.75% 103.1 @ 1.055 MD = 4.23

Well yield differences are very small so I guess it's to make accurate comparisons of the above. TR22 lowest duration has lowest yield, but TY22 and TG22 just look too close to really notice much.

Their yields look so small, I'm not that they are worthy of considerations by small-timers like me and Mel.

Matt

Normally these differences are pretty small I agree. However, you can be fooled into thinking an 8% gilt is a bad deal because the yield is lower than other gilts of the same tenor with 2% coupons. In fact the 8% gilt would have a significantly lower duration than the 2% gilts, justifying its lower yield.

GS
[Are there any 8% gilts left? There were a few years ago.]

[GoSeigen]

f you buy a bond that stands well above par, you guarantee that you lose value if you hold it to maturity and it's only the coupon that compensates.

Mel, this is a faulty way of thinking about investment. Interest and "capital value" are two sides of the same fungible coin. That's why I don't talk about price in relation to valuing bonds or any other investment, but yield. Yield takes account of all the cashflows and is a much sounder way of thinking about value. I strongly recommend you develop a similar conception of investment.

Regarding low gilt yields, that's life today. Gilt yields may be low, and if you think they are too low, don't hold many gilts. But gilts have the advantages that they are traded in the market and their price goes up when risk assets go down. Gilts had yields of less than 5% since 2007, yet on at least three occasions have returned 20-30% within a single year. So the story is a bit more nuanced that "low yield -- not interesting".

To be clear I am not recommending an overweight allocation of gilts right now...

GS

[GoSeigen]

The UK has not yet properly recovered from the financial crisis of 2007-9ish. Hence you should give consideration to what might happen, for example, post brexit and if Jeremy Corbyn started running state socialist policies and what would happen to government debt. I don't think this applies for debt which matures in 2022, but if you had longer dated debt it might be an issue to consider. It takes time for governments to mess things up.

I think you should think very hard about what THIS government has done with debt. They gained power in 2010 claiming the UK was "bankrupt" and could not afford any more borrowing (hence "austerity") but have borrowed more than any government since WW2 if I am not mistaken. Their budget is still not balanced and I can only conclude that they were lying back in 2010 or hopelessly inept (or both!). Ironically a labour government may actually improve matters!

GS

[TheMotorcycleBoy]

if Jeremy Corbyn started running state socialist policies

From an extreme interpretation of the above.....he'd ban private enterprise and nationalise everything!

[Alaric]

but have borrowed more than any government since WW2 if I am not mistaken.

They've been able to borrow at very low coupons, so the additional amounts to be raised in taxation to pay the interest haven't been that great. Where it could go wrong is in the future if interest rates have risen to more normal historic levels and it needs to refinance as issues mature. That particularly applies to the Index Linked ones if the RPI Index rises dramatically.

[TheMotorcycleBoy]

In fact the 8% gilt would have a significantly lower duration than the 2% gilts, justifying its lower yield.

Sorry to be a bit slow here, but why is the lower yield ever a good thing? Is it because, as you said earlier "lower duration" means that you buy this to benefit from a few coupons.....then sell it on? No that can't be right, since lower yield (usually) implies higher price, and you wouldn't you lose out with this approach as the market price approaches par as you move to maturity?

Tell me more....

Matt

[GoSeigen]

In fact the 8% gilt would have a significantly lower duration than the 2% gilts, justifying its lower yield.

Sorry to be a bit slow here, but why is the lower yield ever a good thing? Is it because, as you said earlier "lower duration" means that you buy this to benefit from a few coupons.....then sell it on? No that can't be right, since lower yield (usually) implies higher price, and you wouldn't you lose out with this approach as the market price approaches par as you move to maturity?

Tell me more....

Matt

Matt,

1. Lower duration implies that you get your money back quicker, this exposes you to fewer risks, makes your portfolio more liquid and gives more opportunity to reallocate your investments when opportunities show up. Tying your money up for years has the opposite effects of course: longer time for risks to materialise, less liquidity and little capital to reallocate. For the investor then, lower duration is more desirable and thus a lower yield is acceptable.

2. Shorter duration implies lower price sensitivity to yield. Thus adverse market conditions will lead to smaller market falls if your portfolio duration is low. This lack of volatility is also valuable, so that investors will pay a premium for it (i.e. accept a lower yield). Cash is the ultimate low-volatility asset -- its price is fixed -- and usually attracts the lowest yield.


Because of the above and maybe other reasons you will note that most of the time, in most markets, bond yield curves have a positive slope.

One curious wrinkle is that once duration passes 12 to 15 years or so the yield curve slopes down again (negative slope). The reason for this has been the subject of much discussion which I will not repeat here. I would note though, that right now there seems to be a strong view that perpetual instruments are "good" and that paying a premium for them is justified [for evidence look at recent Aviva preference shares discussions]. In the short term this can result in spectacular profits as perp yields fall [for advanced bond topic, google "bond convexity"], but to me alarm bells are already ringing. In my book perpetual is not better: when many people -- especially amateur retail investors -- start thinking this way I sense danger.


GS