Over the last three weeks, the terms “Gilt” and “Yield” have seemingly been ever-present in news bulletins. Following the announcement of the Government Growth Plan on 23rd September, Gilts have come under pressure, which in turn forced the Bank of England into a temporary position whereby they purchased Gilts, in a move designed to stabilise the market. Let’s go back to basics and look at the importance of Gilts to the wider economy.
What is a Gilt
A Gilt is a loan note issued by the UK Government, who use the money raised by the sale of Gilts to fund public spending. Gilts are issued by HM Treasury and listed on the London Stock Exchange. The term “Gilt” or “Gilt-edged security” is derived from the fact that the British Government has never failed to make interest or capital repayments on Gilts as they fall due. The first Gilt was issued in 1694, to help finance the war against France, and raised a total of £1.2m. By way of contrast, the size of the Gilt market in 2021 topped £2 trillion.
The UK Government is not unique in raising funds in this manner. Most Governments issue loan notes in one form or another. The US issues Treasury Bonds, Germany issues Bunds, and other major nations, such as France, Italy, Canada and Australia also finance public spending in this manner.
Conventional and Index Linked
There are two different types of Gilts listed on the London Stock Exchange. Conventional Gilts comprise around 75% of the Gilt market, and all have two common elements. Firstly, they pay a “coupon” or fixed interest payment, each six months. Secondly, the Gilt has a redemption date, upon which the principal of the Gilt is repaid. This is typically a fixed price of £100.
The remaining 25% of the Gilt market is made up of Index Linked Gilts. These have a redemption date, in the same manner as Conventional Gilts; however, the coupon payments, and the principal value at redemption, are adjusted in line with the Retail Price Index (RPI). This means that the redemption value, and the interest payments, keep in line with inflation.
Common Factors
Whilst Gilts have a redemption date, the fact that Gilts are traded securities will mean that the price will fluctuate over time. Gilt market sentiment is often dictated by prevailing interest rates, and as we have seen over recent weeks, how the market views Government economic policy.
As interest rates rise, this increases the attractiveness of overnight money on deposit, and therefore makes a Gilt look less attractive. The opposite is true, as Gilts generally look more attractive when interest rates are falling. Furthermore, in the situation when interest rates are rising, any new Gilts that are issued will need to offer a higher coupon to attract buyers. This tends to lower demand for existing Gilts which may well offer lower coupons.
The time remaining until a Gilt reaches the stated redemption date will also influence Gilt prices. When a Gilt heads closer to its maturity date, the value of the Gilt will move towards the Gilt’s initial face value.
Finally, inflation can impact on whether Gilts are in demand. Higher inflation, as we have seen over recent months, will reduce the purchasing power of a Gilt’s face value and coupon payments.
How yields are calculated
Gilt yields are often quoted by market participants, rather than Gilt prices, as the yield offers a reflection of the cost of borrowing. The running Gilt yield is calculated by dividing the annual coupon by the current price. For example, if a 5% Gilt is currently priced at £90, the yield is 5.55%. Adding the redemption price into the equation can give an indication of the total return a Gilt holder will achieve if the Gilt is held to redemption. Take the same example of the 5% Gilt, currently priced at £90. Assuming this redeems at £100, then the buyer would also benefit from a £10 capital uplift per Gilt held, to redemption.
Implications for other Bond markets
It is important to note that movements in Gilt markets affect the attractiveness of Corporate Bonds. This is due to the fact that Corporate Bonds tend to trade using a “spread” over the corresponding Gilt, which indicates a risk premium that the holder of the Bond is willing to accept for holding a Bond issued by a company, rather than a Gilt issued by the Government.
Why Gilt Yields matter – mortgage rates and public finances
As market confidence in Government economic policy has ebbed since the Growth Plan was announced, Gilt yields have generally been rising. The Bank of England programme to purchase Gilts stabilised the market a little, although concerns remain over the prospects for Gilts in the short term.
Yields are of importance to the mortgage market, as they affect so-called “swap” rates, which financial institutions pay to other institutions, to acquire funding for future lending. In simple terms, swap rates are a best guess as to where interest rates will be in the future, and tend to move in tandem with Gilt yields.
As Gilt yields rise, any additional Government borrowing will need to offer higher coupons, to ensure there are sufficient buyers for the Gilt issued. Furthermore, as Gilts reach maturity, the Government needs to roll over the borrowing into new Gilts, which again are likely to be at higher interest rates. This increases the interest bill paid by the Government and places further pressure on public finances. For this reason, the Government will want to ensure Gilt yields are brought back under control as quickly as possible.
Likewise, those with a fixed rate mortgage that is due to mature will be well advised to keep a close eye on Gilt yields as an indication of the direction of travel for mortgage rates in the near term.
Where next for Gilts?
Whilst some details of the change in Government policy have already been announced, market participants will still look to the 31st October for full details of the Budget review. The market is likely to be quick to jump on any perceived weakness in Government messaging, following the replacement of Kwasi Kwarteng with Jeremy Hunt as Chancellor. Shortly after the 31st October statement, both the US Federal Reserve and Bank of England will announce interest rate decisions on 2nd and 3rd November respectively. This will, therefore, be a period when further volatility in the Gilt market is likely. At FAS, we will, of course, continue to monitor events closely.
If you would like to discuss the above further, then contact one of our experienced advisers here.
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