How secure are gilts?

The secret of successful investing is having the right balance of assets in your portfolio. Although one type of investment will normally outperform others over any given period, it is usually impossible to predict which one it will be.

Whatever your investment objective, having part of your portfolio in fixed interest securities - more commonly referred to as bonds - is normally seen as a wise move. They provide an element of security and predictability. Bonds are issued by governments and companies.

But, for ultimate security, nothing beats UK government bonds, or gilts, because the government guarantees the income payments and the return of your capital on maturity.

Peter Smart, divisional director and bond specialist at private client stockbrokers Brewin Dolphin, says: "As part of a balanced investment solution, we would always encourage investors to hold part of their investments in gilts, especially now when we live in such volatile times."

How to fit gilts into your portfolio

Just how much you should hold in government securities will depend on your age, objective and personal circumstances. An old rule of thumb was that the percentage you hold in gilts should match your age. So a 50-year-old should hold 50% in fixed income, while a 75-year-old should hold 75%, with the remainder in risk assets such as equities.
Nowadays, the proportion is more likely to be determined by your investment requirements, with the largest exposure to gilts normally recommended in income portfolios.

The Association of Private Client Investment Managers and Stockbrokers (APCIMS) portfolio indices reflect the typical asset allocations that discretionary portfolio managers use. An income portfolio would have a 37.5% exposure to gilts, a balanced portfolio of 20% and a growth portfolio of just 7.5%.

After deciding how much you want to invest, you will need to determine which gilts to buy. Smart explains that this process will involve "considering where we are in the interest rate and economic cycle, and the prospects for inflation, which can have a large bearing on the situation".

There are two main types of gilts. Conventional gilts pay out a fixed monetary income and amount of capital at maturity, and are divided into short, medium and long-dated gilts to reflect their remaining terms. With index-linked gilts, the value of the income and capital is linked to inflation as measured by the Retail Prices index (RPI).
Neither type of gilt has to be held until its redemption date. They are traded on the stockmarket at prices that depend on current and future expectations on interest rates and inflation.

Longer-dated gilts fluctuate more in price than shorter-dated ones because of the greater uncertainty over the long term.

Conventional thinking

At present, longer-dated conventional gilts are producing yields of around 4.5%, while mediums are yielding 3.8% and short-dated gilts 2.8%. Although there are seven or more different gilts in each category, their yields tend to converge.

However, investors are usually advised to buy several holdings maturing in different years, so they do not all mature and require reinvestment at the same time when interest rates may be low.

One leading proponent of investing in conventional gilts is David Kauders of Kauders Portfolio Management, which specialises in constructing whole portfolios of UK gilts, sometimes with a small percentage in US Treasury bonds. They are primarily designed for investors who want a secure long-term income, but they are also suitable for people building up pension portfolios.
Kauders believes now is a good time to invest in gilts. "We are nowhere near the end of the financial crisis," he says. "Bad debts continue to rise and deflationary forces are still strong.
"I believe we are likely to see a long, slow period of deflation similar to the one Japan has suffered, and this is why I think investing in high-quality conventional government bonds is the right thing to do."

Kauders argues that buying long-dated gilts and locking into current levels of income will serve investors well. He does not expect base rates to rise for many years to come: "If interest rates went up, it would bring the whole house of cards down, leading to more bad debts and repossessions, which wouldn't help the banks.

"In my view, we have seen a historic shift to lower interest rates that could last for another 20 to 40 years. It is worth buying stocks yielding 4% now, because by the time the penny drops [that interest rates aren't going up again] the long-term rates on gilts will have fallen below 2%."

Others are less enthusiastic about conventional gilts, because of the large amount of debt the government is issuing to fund extra government spending in the aftermath of the financial crisis.

Tim Whitehead, investment manager at stockbrokers Redmayne-Bentley, believes conventional gilt prices are being propped up artificially because the Bank of England is buying around 50% of the gilts being issued under its quantitative easing programme.
Like many commentators, he expects this process to lead to inflation and believes interest rates will therefore have to rise, which will push gilt prices down again and yields up.
For this reason, Whitehead is also more inclined to consider index-linked gilts, which are currently producing an income yield of 2.4%. This will stay the same in real terms, while investors will benefit from capital appreciation linked to inflation.

He says: "Historically, quantitative easing has always led to inflation. But these stocks do not look excessively overpriced. They are currently pricing in an inflation rate of 1.2% per annum to redemption, whereas the Bank of England's inflation target is 2%. They are a useful way of hedging your portfolio against inflation."
Smart is also keen on index-linked gilts: "They are superb protection against inflation and much better than gold, which many people seem to be opting for at present. Anyone who bought one of the first index-linked issues in 1982 for £100, which mature in 2011, would now have an investment worth £300. Gold has performed nowhere near as well."
Investors do not have to stick to bonds issued by the UK government. It's now easier to buy US or European government bonds through a stockbroker. There are also a handful of managed investment funds specialising in overseas government bonds, and exchange traded funds (ETFs) that track overseas bond indices.

However, Whitehead cautions against them: "Most people invest in gilts because they are risk-averse. If you invest in overseas bonds you are taking a currency risk. I would strongly advise private investors against taking a view on currency."
However, not everyone shares this view. David Thomson, investment director at independent adviser VWM Consulting in Glasgow, says: "We don't particularly like sterling at the moment and we feel the UK is not as well positioned as Europe or the US, so we prefer overseas bonds. The Standard Life Global Index Linked Bond fund is the fund we favour at present."

How to buy gilts

1. Direct

One of the cheapest ways of buying and selling small amounts of gilts is through the government department responsible: the Debt Management Office (DMO). However, it operates on an execution-only basis, so you must know which gilts you want to buy or sell, as no advice will be given.
Stock-dealing forms can be downloaded from the DMO's website or you can call 0845 357 6500. They must be sent with a cheque drawn on a UK bank or building society, or a stock certificate. Buying and selling will normally take place on the day your instructions are received, although purchases will not be finalised until your cheque clears.
You cannot stipulate a maximum buying price or minimum selling price when dealing through the DMO. The cost of buying is 0.7%, or £12.50 - whichever is the lowest - for purchases of up to £5,000. The cost is the same when selling a stock, but there is no minimum charge. Buying or selling securities worth more than £5,000 costs £35 plus 0.375% of the amount in excess of £5,000.

2. Stockbrokers

Purchases and sales of gilts and overseas government securities can be undertaken on an execution-only basis through stockbrokers such as TD Waterhouse, The Share Centre and Interactive Investor.
The advantage of using a stockbroker is that you deal on a same-day basis and at specific prices. However, it can be more expensive. The Share Centre charges 1%, or a £7.50 minimum, while TD Waterhouse has a sliding scale starting at £20 for deals of below £2,000. Interactive Investor charges its standard rate of £10 per trade for gilts and bonds (by telephone only).
If you want to buy overseas government securities, you will also have to factor in the cost of buying the appropriate foreign currency.
Some stockbrokers also offer portfolio management services and will select and manage a portfolio of gilts on your behalf. At Redmayne-Bentley, for example, you will need to have a minimum investment of £50,000. The cost of the service is 1% per annum plus dealing commission.

3. Fund options

Two main types of fund focus on government securities. With an actively managed fund, an investment manager will build up a portfolio of securities that he or she believes will outperform the market in general. With gilts, this normally involves deciding whether to invest in short, medium or long-dated gilts. Specialist index-linked bond funds are also available.
Tim Cockerill, head of research at advisers Rowan & Co, favours the M&G Index Linked Bond fund or, for a more general fund, M&G Gilt & Fixed Interest, as he is impressed by the strength of the group's fixed-income team.

Overseas government bond funds are also available, and Andy Merricks, investment director at Skerritt Consultants, picks out the Standard Life Global Index-Linked Bond fund as his choice.

Annual charges on actively managed government bond funds range between 0.5% and 1% per annum for UK funds, and between 0.75% and 1.5% for overseas bond funds.

For investors who want a spread of bonds, it can be much cheaper to buy a passive ETF that replicates the performance of a relevant index rather than an active manager. There are more than 30 sovereign bond ETFs.

The iShares FTSE UK All Stocks Gilt has a total expense ratio of just 0.2%. European government, US Treasury, emerging market government and inflation-linked government bond ETFs are also available.

This article was originally published in Money Observer - Moneywise's sister publication - in November 2009