Originally posted by Stockbroker, summer 2009.
There was some discussion on a thread the other day relating to Gilt yields. Some readers may be unsure of what these are and how they work so I thought I’d do a piece as there’s not many places to get this sort of information that uses everyday language. Apologies to grannies if this is sucking eggs.There’s nothing magic or mysterious about Gilts. They are just a form of government debt, a Gilt is a government bond, so called because it is gilt-edged and the government will always honour it. Hence you can expect a lower return from a Gilt than from a corporate bond because it is lower risk (companies can go under, the UK theoretically won’t as more money can be printed).
So what I’ll do is just refer to “bonds” throughout but it essentially covers both.
When the government or a company wants to borrow money, instead of going to a bank they can issue bonds. So you hand over your money to the government or the company concerned and get a bond in return. So what are you getting? The bond will have a redemption date and a ‘coupon’, ie Treasury Stock / 5% / 2022. This means that you will get the money back you paid on the redemption date (2022). And in the period you hold it a fixed income twice a year. For a 5% coupon you get 2.5% every 6 months. (Before the experts squeal, this is at a really basic level, there are many different sorts, such as indexed linked etc.).
Let’s have an example. You buy a Â£100 bond with redemption in 2025 and 5% coupon. In 2025 you get your Â£100 back and every 6 months you get a payment of Â£2.50p. You got an income but your capital has been eroded by inflation. So when the government or company issue them, both they and the buyer are taking a bit of a gamble.
The fun though starts in the secondary market where these things are traded daily.
There are millions and millions of bonds and gilts with different redemption dates and coupons out there. So if you found one selling with a 10% coupon it would be a steal right? Well, not really, because you might pay Â£140 for every Â£100 worth of bond you get. Suddenly that coupon is not so good. The immediate or effective yield becomes 10% divided by Â£140 = 7.14%. But the markets don’t use this yield, they calculate the yield to redemption, so it also changes with the number of years left to redemption and the amount of premium/discount you paid. When you hear about yield going up and down, it is this redemption yield on the secondary market they are talking about.
When you pay more than the par or nominal value of a bond you are buying at a premium, when less at a discount. This means that whatever you paid for the Â£100 nominal at redemption (if you don’t sell it on) you only get Â£100 back. Not the amount you paid for it. Redemption yield takes this into account.
Now, if banks are offering savings rates of higher than bond coupons, then those bonds will be traded cheap. You pay less for them so that means their redemption yields are high. On the other hand if banks are offering lower rates than bond coupons, then the bonds will trade more expensively, so their redemption yield will be lower.
The price of the bond will therefore be dictated by what the banks are offering, the guide being BoE rates which LIBOR generally mirrors.
Therefore, interest rates go up, bond and Gilt yields go up because you pay less for them. And obviously when rates are low, bond and Gilt yields will fall because you pay more for them.
Another example. In 2009 you buy a 10 year Â£100 nominal bond (2019 redemption date) with a 5% coupon for Â£110. The immediate yield is 5% divided by Â£110 = 4.55%. But the redemption yield is 3.64%. This is because you have to factor in that you bought it at premium so will effectively lose Â£10 at redemption.
It’s all about supply and demand. Turned out a bit long, but hope it helps.