Are gilts really a safe bet?
If you have been seeking a safe investment haven during the recent economic turmoil, you may have been tempted to invest in the government bonds that have flooded onto the market, in a bid by Chancellor Alistair Darling, to shore up the UK's finances.
Also known as gilts, these bonds enable investors and institutions to lend money to the government in return for a fixed rate of interest.
An impressive number of gilts have been released recently. However, their performance has been less than dazzling.
According to Morningstar, the average Investment Management Association UK gilt fund has fallen by 0.91% over the year to February. Over the same period, the average equity fund in the UK All Companies sector has risen by 29.1%.
"In 2008, as the credit crunch took hold, extreme risk aversion and falling interest rates created huge demand for gilts," says Gavin Haynes, managing director at independent financial adviser Whitechurch Securities.
"However, in 2009, as it became apparent that the worst case economic scenario of global depression had been averted, investors moved from lower-risk areas such as gilts into riskier assets such as corporate bonds and equities, resulting in a strong recovery in these areas and strong outperformance versus gilts recently."
Gilts may be viewed by many as the ultimate safe haven, but is now the right time to put money into them? Are they still the safest available investment? Here we answer your questions about this asset class.
Q: What are gilts?
A: Gilts are basically IOUs from the government. They are traditionally issued at a price of £100 each and redeemed at £100 on a predetermined maturity date. A fixed rate of interest is paid on them each year until this date.
Gilts are denoted by a combination of the coupon rate and maturity date – '4% Treasury Gilt 2016', for example. Plenty of gilts are always available in the market for investors to buy. Most gilts have maturity dates of five, 10 or 30 years.
Q: Is there more than one type of gilt?
A: Several types of gilt are available, but generally the market can be split into two areas: conventional gilts and index-linked gilts. What you decide to buy will depend on the economic climate at the time and your preferences.
With conventional gilts, the government agrees to pay a fixed cash payment – called a coupon – every six months until the maturity date, at which point the initial sum invested is returned. These gilts are divided into short-, medium- and long-dated gilts to reflect their remaining terms.
Index-linked gilts work in a similar way. However, the coupon and the original investment are adjusted in line with the retail prices index measure of inflation to take into account inflation since the gilt was issued. The method used to calculate these cash flows will vary.
Q: Are gilts still a low-risk investment?
A: Gilt payments are guaranteed by the Treasury and are safe unless the government goes bust and defaults on its payouts.
"Despite the perilous state of the economy," says Haynes, "it is very unlikely that you would not receive the return of your original investment together with the promised interest payment (coupons).
Providing you buy a gilt at issue and hold it until maturity, you should receive your original investment and regular interest."
However, it's important to understand that, in so far as gilts are safe, they are only safe if they are bought when they are issued and held until they are redeemed. Between times, their price can rise or fall. If you buy or sell at the wrong time, you can lose out.
Bear in mind, too, that should inflation rear its head, gilts would provide poor returns in real terms, as they provide a fixed level of income.
"An investment paying 4% (currently, a typical yield on 10-year gilts) would not be attractive in real terms if inflation increased markedly," says Haynes - unless it was an index-linked gilt that provides inflation-linked returns.
Q: How can I invest in gilts?
A: There are two main ways to invest in gilts. You can buy them new through a government department called the UK Debt Management Office (DMO) or secondhand on the stockmarket – usually through a stockbroker.
One of the cheapest ways of buying and selling small amounts of gilts is through the DMO. However, it operates on an execution-only basis, so you must know which gilts you want to buy or sell.
This route involves no advice being given. The gilts being auctioned and the dates they will become available are announced by the DMO at the end of every quarter.
To buy gilts that are already in issue, you can use the Bank of England brokerage service on the Bank of England website. You may well find this service has lower commission charges than a stockbroker.
Q: What about investing through a fund?
A: You can, of course, choose a gilt fund run by a specialist manager. There are plenty of these to choose from, whether you want exposure to conventional or index-linked gilts.
Two main types of fund focus on government securities. With an actively managed fund, an investment manager will build a portfolio of securities aimed at beating the equity market.
With gilts, this normally involves deciding whether to invest in short-, medium- or long-dated gilts. Specialist index-linked bond funds are also available.
Q: What about fees and charges?
A: This is an important consideration. While fund charges are significant with all funds, they are especially so with funds at the low-risk end of your portfolio.
"Most people buy bond funds for steady, unexciting returns," says Jason Witcombe, an IFA at Evolve Financial Planning.
"If your expectation of a particular fund is that it will produce returns of, say, 2% or 3% a year above cash, but there is an initial charge and then an annual management charge of 1% to 1.5% a year on that fund, a huge proportion of the return that you expect is being eaten up by charges."
Q: How are gilt markets looking around the globe?
A: With interest rate policies globally moving close to zero and investors becoming highly risk averse, government bond markets in developed countries have generally performed well since 2007. However, like the UK, many European economies have high levels of public sector debt.
Darius McDermott, managing director at Chelsea Financial Services, says: "There are currently huge fears over the health of the European bond fund market – some of which are justified given the parlous economic situations in the unkindly named PIGS countries [Portugal, Ireland, Greece and Spain].
In the US, a reversal of the current loose monetary policy could put pressure on treasuries. As a result, a small but significant number of investors are turning away from the developed nations and looking to the less debt-laden emerging markets."
Looking ahead, the attractiveness of overseas global bonds for investors will largely depend on how long interest rates stay low and when inflationary pressures emerge.
Investors choosing to invest in overseas government bonds need to be aware that they are going to be exposed to currency risk, which can be more volatile than the bonds themselves.
Q: What next for gilts?
A: The Barclays Equity Gilts study published in February predicted that equities will outperform government bonds over the next 10 years, and that they will give an average return of 6.3% a year, or 7.3% with dividends reinvested.
Meanwhile, government bonds are likely to achieve average returns of just 1.6%. Many experts agree that the future looks bleak for gilts.
McDermott says: "Many investors are nervous of gilts – due to the massive size of the UK government's debt and the worry that its credit rating may be downgraded from AAA to AA – and may be keen to avoid them over the coming years." However, he says he remains "neutral" on gilts over the next six months, as they may perform well if the UK economy and stockmarket do badly.
The outlook for the gilt market is uncertain, particularly with governments around the world running large budget deficits and bond issuance running at an all-time high. In the past, the market has easily absorbed increases in issuance because this has coincided with economic weakness and a flight to quality. However, the number of gilts now being issued is now so much higher than it has ever been that people are unsure what will happen next.
Q: So what should investors do?
A: No asset class can provide a solution in every economic environment, but Witcombe believes there is a place for gilts in most portfolios.
He says: "When talking about investment portfolios with clients, many are reluctant to hold fixed interest such as gilts and corporate bonds. They think these are boring and will add no value to the portfolio.
This is simply not the case. We believe that all portfolios should hold an element of fixed interest, with most clients holding upwards of 25% in this asset class."
It's important to have a mix of assets, depending on your medium- and long-term objectives, rather than plough into what looks attractive in the short term.
Many experts say that gilts can be part of this mix, by functioning as the part of an investor's portfolio that aims to produce a better medium to longer-term return than cash, without the volatility of equities.
Q: What are the alternatives to gilts for those who want a low-risk investment?
A: If you're looking for something low risk, but prefer to avoid gilts, there are really two options. One is to invest in cash.
Witcombe says you could opt for a cash equivalent investment, such as National Savings & Investments premium bonds.
Or you could take out a cash ISA or savings account, but as interest rates are still low, you won't get a high return. Another option is to invest in corporate bonds. While slightly riskier, these will produce higher returns, while remaining in the fixed-interest arena.
Q: What happens to gilts if interest rates rise?
A: If interest rates rise, the fixed coupons provided by government bonds look less attractive and prices in the secondary market tend to fall.
Investors may find second-hand gilts on the stockmarket less attractive than placing money on deposit, because the coupon and final redemption value are fixed.
If you think interest rates are about to increase, you might want to avoid government bonds for now. However, many experts forecast that interest rates will remain low for the foreseeable future.
Haynes makes another key point: "Bond markets anticipate future interest rates. By the time interest rates have risen, bond prices will have fallen."
Be aware that it is not just the base rate that shapes gilt prices. Inflationary expectations, the economic outlook, gilt supply and the time to redemption also have an effect.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
A form of National Savings Certificate, premium bonds are effectively gilt-edged securities: you loan your money to the government and, in return, it pays you for the privilege with a guarantee it will return your capital at a specified date. Where premium bonds differ is that the interest payments (currently 1.5%) are pooled and paid out as prize money and you can get your cash back within a fortnight, with no risk. Launched by Chancellor of the Exchequer Harold Macmillan in his 1956 Budget, every single £1 unit has the same chance of winning and in May 2011, 1,772,482 winners (from a total draw of 42,539,589,993 eligible bond numbers) shared £53,174,500. The odds of winning are 24,000 to 1 and the maximum holding is £30,000 per person but it remains the only punt in which you can perpetually recycle your stake money.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Describes the relationship between a client and a stockbroker or independent financial adviser whereby the broker or adviser acts solely on the client’s instructions and doesn’t offer any advice on which shares to invest in or financial products to buy and simply “executes” the wishes of the client, regardless if they are judged to be sound or wrong. Other types of broking service offered are advisory (whereby the client/investor makes the final decisions, but the broker offers advice) and discretionary (whereby the broker manages the portfolio entirely and makes all the decisions on behalf of the client).
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).