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Which gilt to buy?

Investment | Fixed Interest Helpful? 17

Asked by leoncoolvip, submitted 19 July 2010.

Open Quote I want to make an investment in government bonds(gilts) maybe next month and keep the investment for 5 years.
What are your opinions on such an investment in the gilts market?

There seems to be quite a few kinds of gilts. Could you recommend which types of gilts are the most suitable for investment at the moment and keep for 5 years?

In addition, what would be the rough profit out of the investment? For example, if I invest 100,000 pounds, how much profit can I get?
End Quote

Answered by Justin on 19 July 2010

Unless you hold a gilt until redemption you’re at risk of losing money due to movements in interest rates and inflation.

This is because a gilt’s original 100p purchase price can fluctuate between issue and redemption depending on what the market is prepared to pay for it. The ‘coupon’ (i.e. income) on conventional gilts is fixed so they become less attractive when interest rates rise, pushing down their price. Rising inflation also makes gilts less attractive because the value of both future income and your original investment falls in real terms (i.e. they’ll buy less in future due to rising prices).

The sensitivity of a gilt’s price to interest rates and inflation is related to its coupon and length of time until redemption. In general terms the lower the coupon and the longer the period until redemption, the more sensitive the gilt will be to interest rate and inflationary movements.

So when buying gilts there are three main features to look out for:

1. The date when the gilt will redeem.
2. The gilt’s ‘coupon’, i.e. how much interest it’s paying.
3. Whether the gilt is linked to inflation.

You can get all this information from a gilt’s name. For example, the 8% Treasury Stock 2015 returns the original 100p loan in 2015 (7 December 2015) and pays 8p annual income meanwhile. When a gilt mentions index-linked in its name, then both the income and the original loan increase with inflation until redemption.

Provided you hold a gilt until redemption it’s possible to calculate how much money you’ll make. In the case of the 8% Treasury Stock 2015 the purchase price is currently about 129p with an annual coupon of 8p. An 8p annual income on 129p sounds good until you remember that you’ll only get back 100p in December 2015 at redemption. What we need to do is calculate a ‘redemption yield’, which shows the equivalent annual return including the loss. In this case it’s 2.24% before tax (you can use our Redemption Yield Calculator to work these out).

The return doesn’t look very attractive versus the best buy bank and building society five year fixed rate savings accounts currently available (e.g. 4.75% gross), but reflects the additional perceived safety of lending your money to the Government rather than a bank.

If you buy £100,000 worth of the above gilt you’d expect to receive annual income of about £6,200 (for 5 years and 5 months) plus the return of £77,520 at redemption.

Of course, there are plenty of other gilts with differing coupons and redemption dates, I just used the above as an example, but hopefully this gives you an idea of what to expect.

Index-linked gilts are more complicated because both your income and redemption value depend on inflation, so you can’t be certain of how much you’ll receive. Suffice to say if you think inflation will remain high they’re worth considering, but avoid if you think inflation will fall.

Hope this helps and please remember that the only way you can be certain of the return on a gilt (excluding index-linked) is to hold it until redemption.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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Readers' Comments (1) - To post a comment please register or login .

Comment by leoncoolvip at 10:50pm on 19 Jul 2010:

Thanks Justin!!

You are the best!!