What Is a Gilt?

Bonds issued by the UK government, known as gilts, are considered to be a low-risk investment due to the creditworthiness of the UK government. This can make gilts an attractive prospect for risk-averse investors seeking to generate reliable income from their portfolio. 

In this article, we will take an in-depth look at gilts, explain what they are, how they work and what to consider before buying them. Keep reading to find out all this and much more! 

Understanding Gilts

Gilts are government bonds which are issued by the UK Debt Management Office (DMO) on behalf of His Majesty’s Treasury and listed on the London Stock Exchange (LSE). As with other types of bonds, when investors buy gilts, they are effectively lending money to the UK government at a predetermined rate of interest.

Government bonds are typically considered to be a low-risk investment; however, in reality, the level of risk depends entirely on the government in question. The UK government has never failed to make interest or principal payment on its gilts, which were first issued in 1694 by the Bank of England to help finance King William III’s war with France.

Consequently, gilts have a reputation for being amongst the lowest-risk investments available, which might appeal to the more risk-conscious investors out there. However, as is generally the case, this lower level of risk is accompanied by a lower level of return.

Types of Gilts

There are two different types of gilt which are issued by the UK government: Conventional Gilts and Index-Linked Gilts. 

Conventional Gilts

The vast majority of gilts issued by HM Treasury are known as conventional gilts. For those who are already well-versed about bonds, the way conventional gilts work will sound familiar.

The UK government guarantees to pay the holder of a conventional gilt a fixed payment, known in bond-speak as a coupon, every six months until such a time as the gilt matures. On the maturity date, the bondholder receives the final coupon together with the repayment of the principal (the amount initially invested).

Conventional gilts are quoted in terms of price per £100 face value and are denoted by their coupon rate and maturity date.

The face value, or nominal value, of a bond represents how much money was initially lent to the bond issuer and, consequently, how much the bondholder will receive at maturity. The coupon rate represents how much cash the bondholder will receive per year per £100 nominal value the bondholder owns.

For example, for every £100 nominal held of 1% Treasury Gilt 2040, the holder will receive £1 a year (in two semi-annual payments of £0.50) until the gilt’s maturity date in 2040. On the maturity date, the holder will receive the final coupon of £0.50 plus repayment of the £100 nominal.

Index-Linked Gilts

In 1981, the UK government became one of the first developed economies to start issuing index-linked bonds to investors.

Index-linked gilts are pretty much the same as conventional gilts but with one key difference. As with conventional gilts, the holder of an index-linked gilt is entitled to a semi-annual coupon payment until the gilt matures, at which point they receive repayment of the principal in addition to the final coupon.

They are also denoted in the same manner as conventional gilts, although are referred to as Index-Linked Treasury Gilts as opposed to simply as Treasury Gilts.

However, unlike conventional gilts, the coupon and principal repayments of index-linked gilts are adjusted in line with the UK Retail Prices Index (RPI) - which is a measure of inflation.

Consequently, index-linked gilts offer investors protection against the negative effect of inflation by accounting for RPI increases between when the gilt was first issued to when each coupon payment and, ultimately, the principal repayment takes place.

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The Gilt Market

Up until 1998, gilts were issued by the Bank of England (BoE) on behalf of the Treasury. However, in April 1998, the year after the BoE was given independence to set interest rates, the responsibility for issuing gilts was transferred to the newly formed Debt Management Office.

The DMO, which is responsible for debt and cash management for the UK government, issues gilts in the primary market through auctions to Gilt-Edged Market Makers (GEMMs). GEMMs are banks or securities brokers which are authorised to buy gilts in the primary market.

Historically, only institutional investors were able to access the primary gilts market; however, recently there have been instances of GEMMs working with brokers to offer retail investors the opportunity to buy gilts in the primary markets.

Investors can also buy and sell gilts in the secondary market through many stockbrokers or using the DMO’s Purchase and Sale Service.

Key Figures in the Market

Although private investors can, and do, invest in gilts, they make up only a very small proportion of total ownership of government debt. At the time of writing, according to the DMO, there is more than £2.3 trillion of gilts in issue. So, who else buys UK government bonds? 

Bank of England

At the time of writing, the BoE holds more than £650 billion worth of gilts. There are two main reasons why the BoE owns UK government bonds:

• Quantitative Easing (QE)
  • After the global financial crisis in 2008, the BoE began using QE for the first time in order to stimulate the UK economy. At the time, the base interest rate was 0.5%, meaning there was not much scope to reduce it further. Instead, the BoE began using QE, which involves buying bonds in order to increase the money supply and bring down long-term interest rates.
• Stability 
  • There are times when the BoE may step into the gilt market to restore stability during times of turbulence. For example, in 2022, the UK government at the time introduced a “mini-budget” which spooked the markets and caused yields on gilts to soar as traders offloaded UK government bonds (bond yields and prices have an inverse relationship). In response, the BoE stepped in and began buying gilts in order to restore stability.

Institutional Investors

Institutional investors are entities which invest large sums of money on behalf of their clients.

Typical examples of institutional investors include pension funds and insurance companies and, indeed, these two entities tend to be big buyers of gilts in the UK due to the relatively low-risk nature of the investment. In particular, insurance companies are obliged to hold a large percentage of their cash in "safe" investments, in order to be able to back their policies.

What to Consider Before Buying Gilts

We’ve already noted that gilts are considered a relatively low-risk investment due to the fact that the UK government is incredibly unlikely to default on its debt. However, there are still things to consider.

On the secondary market, gilt prices are determined by supply and demand, just like any other freely traded asset. Interest rates can play a big part in influencing supply and demand and, consequently, gilt prices.

When interest rates increase, it makes gilts which are already in circulation less appealing, as their coupons become less attractive. This can reduce demand and increase supply, as people are more inclined to sell bonds than buy them.

Consequently, when UK interest rates rise, gilt prices tend to fall and vice versa. Gilt prices and yields have an inverse relationship, meaning that rising interest rates push up gilt yields whilst lower rates pull them down. Accordingly, when considering investing in gilts, interest rates are a key consideration.

Another thing to bear in mind is inflation. Whilst the coupons and principal repayments of index-linked gilts are adjusted in line with inflation, this is not the case for conventional gilts, and it is conventional gilts which make up the bulk of the gilt market.

Thus, investors should also consider the outlook of inflation in the UK before investing in conventional gilts, as an inflationary environment can erode the real value of returns.

Conclusion

Gilts are UK government bonds which are generally seen as low-risk due to the creditworthiness of the UK government, which is afforded a high credit rating.

Thus, for risk-averse investors, who are interested in preserving capital whilst generating reliable income, gilts may be a good option. However, before buying gilts, it is important to understand the negative effect inflation can have on their returns and interest rates can have on their prices. 

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.