Gilts and Bonds
These have been popping up in the news recently - thanks to chaos in the USA and interesting developments in Japan. (Full disclosure: I'm writing this a couple of weeks ahead, so things may have shifted by the time you read this!)
Gilts and bonds have traditionally been the domain of professional investors and remain less accessible to everyday investors than shares. But they're an important asset class for balancing risk and - in the case of gilts especially - a huge part of our economic and political system. So they're worth understanding, even if you're not buying them directly.
What Bonds and Gilts Are Not.
First things first, these are not Premium Bonds, and they’re also not savings bonds (which you can also get from NS&I and other banks). Both of those are savings products rather than investments and they can’t be traded like the bonds and gilts we’re going to talk about.
So What Are Bonds And Gilts?
They’re essentially loans that you give to a government or to a corporation which will be paid back at the end of a term and which pay interest in the interim. They can be traded and the price fluctuates according to market demand but the interest and the face value of them don’t change - whether the interest or face value is a good deal depends on the market.
Gilts are what the UK government issues.
In the US these are called Treasuries.
Bonds are what companies issue and are sometimes called corporate bonds.
There is Some Gilt-and-Bond-Specific Language:
Par Value - is the face value.
This is the price of the gilt and what will be paid at the end of the term.
Coupon - is the interest
This is usually a fixed % and paid twice a year.
Redemption Date - is the payback date.
When the gilt will be paid back - these range from less than 1 year to 50 years in practice.
So if the par value of a gilt is £100 and it has a fixed 4% coupon, you’ll get £4 a year until the redemption date, and then £100 back at that point.
The Value of Gilts and Bonds
Imagine you have a gilt which pays 4% and the average savings account pays 2%. You’re quids in and it’s in demand!
If savings accounts are paying 6% then, not so much.
Inflation is a big issue - £4 a year bought you 40 Freddos in 2000, but only 16 now so that gilt will be less valuable.
£100 is also ‘worth’ a lot less now than it was in 2000 when the redemption date comes - could you have made more in stocks and shares?
There are index-linked gilts which mitigate this by tying both the coupon and the par value to the Retail Price Index (RPI), this means they increase as inflation increases. (In 2030 they will start to use a different measure, CPIH (Consumer Price Index including occupiers’ Household costs) which historically tracks inflation a little lower than RPI and there is some controversy but, let’s park that here and maybe come back later).
The value of gilts and bonds is a delicate balance between interest, face value and market value so there are complex formulas to work that out which we don’t need to get into in depth right now.
The key one is probably the ‘redemption yield’ which calculates your total return if you hold the bond to maturity, accounting for both coupon payments and any difference between purchase price and par value.
But it gets way more in depth than that!
Gilts and Bonds for Diversification
Stocks and shares have more or less unlimited potential to grow both in value and returns - limited only by how well the company does - but with gilts and bonds the returns tend to be lower, because they’re for the most part determined at the beginning of the investment.
However, bond interest does need to be paid even if profits are down 50%, unlike dividends which don’t have this requirement. So they’re considered a much lower risk investment and they’re used in portfolios and funds as a balance for the instability of stocks.
For them not to be paid means the business or country is in dire straits (though this is rare for investment-grade bonds). For gilts not to be paid would require sovereign default, which is extremely rare for developed nations like the UK.
To account for this there are agencies which evaluate the level of trust-worthiness on a scale from AAA or ‘highest quality’ to junk bonds - like a credit score. The further down that scale, the higher the interest has to be to account for the higher level of risk the investor is taking.
Issuing gilts is one way in which the government makes money, it is government debt, if the government’s credit rating is lower then the interest to be paid is higher and borrowing is more expensive.
Bond-Specific Stuff
Generally, companies are seen as less stable than governments - more likely to default and therefore the bonds they issue are higher risk and so the returns must be higher.
Because of this, there is a more varied range of bonds available. Some of the main types are:
A Debenture: This is a loan secured on an asset - which can be specific or general - so if it all gets messy then there’s something tangible to account for it.
Convertible Loan Stock: This is a type of debenture which allows the owner to convert the loan into company shares later on.
Zero Coupon Bonds: These don’t pay interest (as the name suggests) but you buy them at a significant discount to the par value but get the full value back at the redemption date.
The Tax Situation for Gilts and Bonds
Gilts and bonds are taxed a little differently so we’ll take them separately.
Gilts:
Coupon (interest) - is taxed as income so just at whatever tax rate you pay after your Personal Savings Allowance (PSA).
Capital gains if you sell at a profit - None at all!
Bonds:
Coupon - same as gilts, taxed as income after your PSA.
Capital gains - it depends.
If it’s a Qualifying Corporate Bond (QCB), if it is then no Capital Gains Tax (CGT) and,
if it isn’t (like a convertible loan stock) then there is CGT.
Some types (like a zero coupon bond) might possibly count as income rather than capital gains, if you’re at this point, it’s definitely worth getting advice.
You can hold bonds and gilts in ISAs and then you’d pay no income tax or CGT!
Accessing Bonds and Gilts
I suspect most of us here will be accessing bonds and gilts through funds - possibly index funds or pension funds. Buying individual gilts typically requires a minimum investment of £1,000 ish but funds can be accessed for much smaller amounts. In funds, managers use bonds to level out the risk of shares (maybe along with other asset classes).
Shares have nearly infinite potential but they can also go squelch if the business fails, this makes them a rollercoaster ride. High quality bonds and gilts are much more guaranteed (although, nothing is absolute!), mostly because you’ve got that set coupon, set redemption date and set par value.
In this way if you have a fund which is heavy on shares, it’s more likely to go up in value but it also might be a rougher ride. Platforms often offer a range of funds which are differentiated by the ratio of bonds to shares - for example 100% shares, 50/50 shares and bonds, or 100% bonds.
You may have heard of the Lifestyle or Target Date type funds - these start heavily invested in shares as you begin your investing journey but as you approach retirement age, they start to sell off the shares and buy in bonds to conserve the wealth that’s been created.
The reason I point this out is because this might be a really great way to edge your way into investing. Even if you’ve been reading along and understanding everything in the blogs and newsletters, you know you’ve got to get going and you’re feeling inspired - if the thought of investing (as opposed to saving) really makes your heart lurch, then a fund which is heavy on bonds might feel like a good middle ground or a safe first step.
Let me leave this there because it’s been a long one. I actually find bonds and gilts (gilts especially) really interesting. It seems to be one of those concepts which means more than people are talking about on the surface - politicians and the like.
I also love, as usual, the little connections with history. Gilts are so called because they used to have gilded edges (literally gold!).
There will be a little more on the political situation around gilts in this week’s newsletter. Have you signed up?
Love Eleanor. xxx
