Are gilts still a reliable investment?

18 June 2009

Chancellor Alistair Darling’s desperate bid to keep the country’s finances afloat by borrowing a staggering £220 billion over 2009 has thrown the spotlight onto the traditionally overlooked world of government bonds.

These products – known as gilts – enable individuals and institutions to lend money to the government in exchange for a fixed rate of interest, paid twice a year, and the repayment of the bond’s face value at a pre-agreed future date. They are currently being issued in huge numbers to raise the vast sums needed to cover the UK’s spiralling public debt caused by a combination of rising unemployment, a beleaguered housing market and diminishing tax receipts from the City – and, of course, to cover the huge cost of the banking bailout.

But the question is whether investing in gilts makes sense. Is now the right time for people to put their money into this asset class, or are there better options elsewhere? And how safe are these investments that have traditionally been classified as ultra-safe, given the state of the country’s finances?

How gilts work

Before you draw any conclusions, it’s important to know how gilts work.

Gilts are basically IOUs from the government, making them the ‘safest’ available form of debt. So while they can never lay claim to being the sexiest asset class around, they are the closest to a risk-free investment you are ever likely to find, according to Geoff Penrice, a financial adviser with Bates Investment Services.

“As they are backed by the government, we can assume there is no risk of default,” he explains. “However, this lack of risk also means that, on average, the returns from gilts will be lower than those from, say, corporate bonds.”

However, the minimal level of risk associated with gilts has actually paid off during the economic crisis that has gripped the world over the past 12 months. While virtually every asset class has been in freefall, gilts have been the only area where investors have made money.

Although there are many different types of gilt, the market can be broadly split into two distinct areas – conventional gilts and index-linked gilts. The economic environment will dictate which should be bought at any particular time.

With conventional gilts, the government agrees to pay the holder a fixed cash payment – known as a coupon – every six months until the maturity date, at which point the initial sum invested (also known as the principal) is returned.

Index-linked gilts work in a similar way, but both the coupon and the principal are adjusted in line with the retail prices index measure of inflation. This means that both will take into account inflation since the gilt was first issued, although the method used to calculate these cash flows will vary, depending on the date when they were first issued.

Which route you take depends on your outlook for the economy, says Andy Gadd, head of research at IFA Lighthouse Group. “If you are concerned that the current measures being implemented by the government -– quantitative easing and the lowest base rate in history – are stoking up inflation in the future, then now may be a good time to buy index-linked gilts,” he explains.

How can you buy gilts?

There are two ways to invest in gilts. You can either buy them ‘new’ through a government department called the UK Debt Management Office (DMO), or ‘secondhand’ via the stockmarket, usually through a stockbroker.

The public can only buy via the DMO at gilt auctions if they are a member of the Approved Group of Investors. The gilts being auctioned and the dates they will become available are announced by the DMO at the end of every quarter.

The other option is buying them via the stockmarket. As gilts are actively traded securities, their price can change continually during an average day. Prices fluctuate as people change their views about the prospects for base-rate movements and the demand and supply of gilts. For example, a coupon that’s fixed at 6% may look very attractive when the base rate is at 3%, but it will not appear quite so enticing if it rises to 8%.

It’s important to understand that the safety aspect of gilts only applies if they are bought when they are issued and held until they are redeemed. Between these dates, their price can rise or fall. This means that if you buy or sell at the wrong time, you can end up losing out.

Gilts are denoted by a combination of the coupon rate and maturity date, for example ‘4% Treasury Gilt 2016’, and there are always plenty of gilts in the market at any one time that investors are able to buy. Most gilts have maturity dates of five, 10 or 30 years.

If you don’t wish to buy individual gilts you can opt instead for a gilt fund that is run by a specialist manager. There are plenty of these to choose from, regardless of whether you want exposure to conventional or index-linked gilts.

The benefit of buying a gilt fund is the ability to tap into the expertise of a specialist in this area, according to Darius McDermott, managing director of Chelsea Financial Services. “Even in this information age a fund manager is still likely to have access to more information than an individual investor,” he says. “They will be able to decide which gilts offer the best ratio of risk and reward.”

McDermott suggests the City Financial Strategic Gilt Fund, managed by Ian Williams, could be worth a look. “He will allocate between conventional and index-linked gilts as appropriate – and those are the sort of switches more easily made by a fund manager than a private investor.”

Whatever you decide to do there should always be a place for gilts within your portfolio, regardless of which form you choose, according to Darren Ruane, a bond strategist at Rensburg Sheppards Investment.

“It is good to have some insurance so that when the rest of the economy goes wrong, a part of your portfolio stands up and retains its core value,” he says.

This is perfectly illustrated by the performance of gilt funds - particularly in comparison to corporate bonds and equities, according to figures compiled by the Investment Management Association (IMA).

The average IMA UK Gilt fund has returned a very impressive 8.9% over the past year to the end of March 2009, at a time when stockmarkets around the world have been in virtual freefall.
Over that same period, the average equity fund in the UK All Companies sector has lost a staggering 31.5%, while similar falls have been experienced in the Europe excluding UK, Global Emerging Markets and UK Smaller Companies sectors.

This shows gilts’ attractiveness, says Stuart Thomson, economist at Ignis Asset Management – despite the fact that the asset class has struggled to appeal to investors who have been more focused on higher-risk areas of the market.

“Gilts have been one of the forgotten instruments and haven’t been seen as sexy as far as the market is concerned,” he says. “However, they have outperformed equities and bonds, so this oversight will have cost investors a lot of potential gains.”

What next for gilts?

That being said, the outlook for the gilt market is uncertain. The huge volume of gilts being issued over the coming year could certainly affect the supply/demand dynamics and therefore affect prices over the medium term.

This is a trend that’s likely to continue, according to Geoff Lunt, manager of the HSBC Gilt & Fixed Income fund. “There is a massive deluge of supply around the corner and that’s not likely to let up anytime soon,” he says. “There is £220 billion to come this year and we’ll almost certainly have something similar next year.”

For the gilt market this is unknown territory. “In the past, the market has easily absorbed increases in issuance because they coincided with economic weakness and a flight to quality,” he adds. “However, the numbers being issued are so much higher than they have ever been before that people are unsure what will happen.”

The failure of a £1.75 billion gilt auction in March this year, for example, made some market-watchers jittery, although a subsequent auction of index-linked gilts was heavily oversubscribed, helping to calm these nerves. “We don’t really know why the first auction failed, but I don’t think people should read too much into it,” says Lunt at HSBC. “These things can happen and, in my opinion, it’s not the calamity that it was painted to be.”

Even so, market reaction over the next few weeks is likely to be crucial, points out Edward Bonham Carter, chief executive of Jupiter Asset Management.

“If the market thinks the chancellor’s assessment of the situation credible, then it should be able to absorb this massive increase in borrowing and gilt issuance,” he says. “If investors perceive the UK economy as unattractive, they may prefer to buy the billions of dollars being issued by other recession-hit governments such as the US.”

This, he adds, could result in long-term interest rates shooting up, borrowing becoming more expensive and sterling possibly weakening.

However, this doesn’t mean gilts should be avoided, says Darius McDermott at Chelsea Financial Services – but caution definitely pays. “I’m not saying you shouldn’t buy gilts, but investors need to be a little bit more careful given the huge amounts of issuance,” he says. “There is a supply and demand issue, which will affect the price, and there are potentially inflationary consequences of printing money.”

So what is the conclusion? Well, no asset class can provide a solution in every environment, and this is no different with the current economic backdrop, points out Geoff Penrice at Bates Investment Services.

“The important thing is to have a mix of assets depending on your medium and long-term objectives, rather than ploughing into what looks attractive in the short term,” he says. “In that respect, gilts certainly have a part to play in most portfolios.”

How interest rates can affect gilts

Interest-rate movements can be either good or bad for gilts, explains Gadd, head of research at IFA Lighthouse Group:

“A conventional gilt provides a fixed coupon or interest payment over its life, and repays a fixed capital sum at maturity. This means that before maturity gilt prices are affected by a number of factors, one of the most important being the prevailing level of the base rate and whether it is likely to rise or fall.

“If the base rate rises, then those purchasing gilts ‘second-hand’ on the stockmarket will find them potentially less attractive than placing money on deposit, because both the coupon and the final redemption value are fixed.

"In order to address this, it is likely that the prices of gilts on the stockmarket will fall, making the coupon and final redemption value more attractive to buyers in order to compete with the new higher return available from cash deposits for investors purchasing gilts.

“Of course, if the base rate was to fall, then the reverse would be true and it would be likely that the trading price of conventional gilts would rise.

“However, it is not just the base rate that can affect the price of gilts. Prices may be shaped by inflationary expectations (with the exception of index-linked gilts), as well as by factors such as the economic outlook, the supply of new gilts and the time to redemption.”

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