Demystifying Bonds and Gilts.
There is a great deal in the press this week about Gilts and bonds, so we thought it may be useful to explain briefly what they are and what is happening at the moment:
Bonds are a debt based investment that provide a fixed rate of interest for a fixed term. The term bonds can refer to Gilts issued by the UK government or Corporate bonds issued by UK companies like Lloyds Bank, BP and Shell etc.
Gilts are issued by the Debt Management Office, and are used to raise capital for the UK government to use in its management of the country. They are considered “risk free” assets because the UK government is always expected to be able to repay them.
They are bought by large institutions in the UK, life assurance companies, pension providers, foreign governments and investors and private investors from the UK.
Bonds offered by companies instead of the government are called corporate bonds. Corporate bonds are not as safe as Gilts as it depends how good the company is that is issuing them to raise money for its expansion and development.
The “Bonds” in the news this week are Gilts issued by the UK government.
A bond will be issued at a par value, normally £100 and pay a fixed interest for a fixed period.
For example, if you invest £10,000 in a 5 year bond paying 4% interest, you would get 100 bonds worth £100 each and you will receive £400 each year for 5 years. At the end of that period you will get back your original £10,000.
Because they pay a guaranteed fixed income, organisations like pension companies buy them to guarantee their cashflow to be able to pay the required monthly income to pensioners.
For many years these pension companies have also bought Gilts and then loaned them out to other institutions for a higher rate of interest and used the money raised from this to buy more Gilts, and then repeated this process.
This is piece of financial wizardry that works great, until something comes along to upset the apple cart. The company gets a guaranteed return either from the Gilt or from the company it has loaned them too and this can be leveraged in to a greater profit by buying more as mentioned above. Meanwhile the pensioners still get their money each month.
When it all goes wrong
Gilts have an inverse relationship with interest rates – when interest rates go up, (which they are at the moment in an attempt to combat inflation) Gilt prices come down. This happens because the Gilts must compete with the return investors can get from the bank to make them attractive.
So, everyone talks about the Yield – If you Invest £100 and receive £5 interest you have a 5% yield.
But if you buy the same gilt for £80 and get £5 interest the yield goes up to 6.25% (5/80 x 100 = 6.25)
So rising yields are a bad sign for gilts because it means they are worth less because prices are having to reduce to compete with cash investments at the bank.
Bonds also react badly to rising inflation, because the income they pay is worth less in real spending power terms.
You would be right in thinking, so what’s the problem, just hold it until maturity and get back your original investment which is guaranteed?
There is no problem with that and nothing to worry about if that is your strategy.
But if you bought the Gilts to receive a fixed interest of say £2,000 a year and inflation is making the real spending power of that less, the Gilts are no longer so attractive. Because of this their value will go down.
So if you are a pension company needing to provide a guaranteed pension income that keeps pace with inflation, you need a better return, but if you sell your Gilts to buy a better investment you will lose money, so you are trapped.
You MUST still make the required pension payments but the income you receive from Gilts is not enough so you have to sell them at a loss to buy something better or sell other assets to raise money to be able to make the pension payments.
Because Gilts are the favourite strategy of pension providers of Final Salary or defined benefit schemes as well as annuity providers, this is why they hit the news this week.
The chancellors new budget cut UK taxes significantly – reducing government income, which spooked the markets because that may lead investors to question whether or not the UK government would have enough income to repay gilts when they mature, so Gilt prices fell significantly.
At the same time, the pound fell massively against the dollar because the UK government was seen as maybe not being a safe place to invest.
So rising interest rates, inflation, reduced government income in the coming years all combined to collapse gilt prices and nearly make some large pension providers insolvent.
If you would like to learn more about this and how it may affect you, please do not hesitate to get in touch.