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.
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
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.
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
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
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.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
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%.
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.
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).
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
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).
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
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).