Gilts: a short guide to government bonds
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UK government bonds – also called “gilts” – can be an attractive option for investors who are focused on mitigating risk, providing income and diversifying their portfolios. Yet what are gilts, exactly? How do they work, and what are the best ways to include them in an investment plan?
Our Lincolnshire financial advisers offer a short guide below to answer these questions. We hope these insights are helpful. To discuss your own family financial plan with us, please get in touch to arrange a no-obligation financial consultation at our expense:
01476 855 585
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What are gilts?
Gilts (UK government bonds) are issued by the UK Treasury. By doing so, the government is asking to borrow money from investors.
The latter can choose to lend by buying bonds, containing an agreement that the amount borrowed from the investor will be repaid – with interest – at a specified “maturity date”.
The interest offered to investors is called the “coupon”. The Bank of England’s “base rate” of interest plays a crucial role in determining the level of interest. As a general rule, the higher the base rate, the more expensive it will be for the UK government to borrow.
This means that newly-issued gilts may offer investors a higher coupon than older ones which have already been purchased. The latter, therefore, may be less attractive to other investors – requiring current bondholders to lower their selling prices.
Here, we are starting to touch upon the “secondary market” for bonds. The “primary” market is where investors buy bonds (e.g. gilts) from borrowers. The “secondary” market is where investors can subsequently trade these bonds with each other.
What are the different types of gilts?
The UK government offers a range of gilt options to investors to try and reflect the needs of bond issuers and holders. The most common type is the “conventional” gilt, which involves the government paying a fixed rate of interest (coupon) semi-annually until maturity.
Another important type is the index-linked gilt (ILG). Here, the principal (amount borrowed) and the interest are adjusted over time based on changes in the UK Retail Prices Index (RPI).
The intention is to provide inflation protection to investors. However, if inflation falls, then investors could lose out financially.
Gilts can be classed as “short” or “long” depending on their maturity dates. The shortest is known as a “treasury bill” and lasts three months. The longest is up to 50 years. Medium-term gilts fall somewhere in between, such as 5-15 years.
How should gilts be integrated into a portfolio?
The suitability of gilts (UK government bonds) in a portfolio depends heavily on the individual investor’s goals, risk tolerance, current asset allocation and investment horizon. The wider macroeconomic context is also an important factor.
Gilts are widely regarded as “safer” investments compared to equities (shares) because they are backed by the full faith and credit of the UK government – which has never defaulted. This means that gilt investors can have high confidence that they will get their money back.
As such, UK government bonds can be attractive for “cautious” investors who are less comfortable with the market volatility involved with investing in shares. The regular payments from bond coupons can also be useful to investors who want their portfolios to generate a regular income (e.g. in retirement).
Gilts can also be helpful as a diversification tool. This is because bonds typically have an inverse relationship with equities. When bond prices rise, share prices tend to fall – and vice versa. Therefore, including a balance of the two asset classes within a portfolio can mitigate its overall volatility in the short term. For investors wanting to preserve the value of their wealth (e.g. as they prepare to buy an annuity for retirement), this can be very helpful.
However, gilts have drawbacks, and it is important to weigh them with your financial adviser. Inflation risk can undermine conventional gilts since fixed coupon payments will lose their purchasing power over time if inflation rises.
Investors can mitigate this risk by opting for inflation-linked gilts (ILGs). If future inflation turns out to be lower than expected, then the investor’s returns may be lower than if a conventional gilt had been purchased instead.
Interest rate risk is also important for investors to consider. If future rates go up, then the value of your bonds (in the secondary market) could fall. This might not be a concern if you plan to keep your gilts until their maturity dates, enjoying the coupon payments in the meantime. However, this risk becomes more pressing if you may need to sell certain gilts before then (e.g., to rebalance your portfolio).
A final risk to consider is opportunity cost. Generally speaking, gilts offer lower potential returns over the long term compared to equities. Therefore, investors who will not need their money for a long time (e.g. in 30 years when they retire) may experience more investment growth by focusing their portfolios on equities – with the help of a financial adviser along the way!
Invitation
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
01476 855 585
info@casfin.co.uk
