WEEK 4

Gilts & Corporate Bonds

Learning Objectives

• Understand the features, suitability & characteristics of various types of fixed interest investments:

  • Gilts

  • Interest linked gilts

  • Corporate bonds

  • Other types of bonds

• Understand the pricing of bonds

• Explore return measures – yield and yield curves

• Examine the risks of holding bonds

Fixed Interest Securities

Definition

• Fixed interest securities are investment products that provide a fixed return over a specified period.

Characteristics

• Issuers: Entities that issue bonds such as governments or corporations.

• Main features of fixed interest bonds:

  • Fixed redemption value: The amount returned upon maturity.

  • Fixed annual rate of return: The interest rate that remains constant over the investment period.

  • Specified redemption date: Date when the bond matures and the principal is repaid.

Gilts

Characteristics of Gilts

• Government bonds issued by the UK government.

• Types of gilt:

  • Shorts: Bonds with short maturities.

  • Mediums: Bonds with medium maturities.

  • Longs: Bonds with longer maturities.

  • Undated: No fixed maturity date.

Index-linked Gilts

• Bonds where the interest payments and redemption value are linked to inflation indices.

Gilt Markets

• Repo: Repurchase agreements allowing for securities financing.

• Strips: Separating bond components (interest payments and principal) into individual parts for trading.

Taxation of Gilts

• Understand taxation policies that apply to gilt returns.

Gilt Pricing

• Analyze short & long-dated gilt prices.

Buying and Selling Gilts

• Understand the process of acquiring new issues through auctions, non-competitive bids, and reverse auctions.

Corporate Bonds

Characteristics

• Issued by corporations for financing; typically offering higher yields than gilts.

Differences from Gilts

• Corporate bonds carry different risk profiles than gilts.

Types of Corporate Bonds

• Debentures: Long-term securities yielding a fixed rate.

• Fixed & Floating Charges: Claims over assets in case of default.

• Trust Deeds: Address bondholder rights & responsibilities.

• Convertible Loan Stocks: Bonds that can be converted into shares.

• Zeros & Deep Discount Securities: Bonds sold at discounts without periodic interest payments, understanding tax implications is crucial.

International Bonds

• Eurobonds: Bonds issued in a currency other than the currency of the country in which they are issued.

• Eurodollar Bonds: Denominated in U.S. dollars but issued outside the US.

• Bulldogs, Yankees, Samurai, Matilda, Shogun Bonds: Types of foreign bonds, each with unique characteristics based on currency and location.

Other Fixed Interest Securities

• Floating Rate Notes (FRNs): Bonds with variable interest rates attached to them.

• Local Authority Bonds: Government-issued bonds with certain taxation and risk profiles.

• Permanent Interest Bearing Shares (PIBS): Securities issued by building societies.

• Perpetual Subordinated Bonds (PSBs): No maturity date, issued for long-term funding.

Risks of Holding Bonds

• Interest Rate Risk: The risk of bond prices falling when interest rates rise.

• Inflation Risk: Erosion of purchasing power affecting real returns.

• Liquidity and Marketability Risk: Difficulty in selling a bond in the market.

• Issue-Specific Risk: Risks associated with the bond issuer's credit quality.

• Fiscal Risk: Impact of government fiscal policy on bond viability.

• Currency Risk: Risk associated with bond investments in foreign currencies.

Ratings & Bond Volatility

Credit Ratings

• Assessment of the creditworthiness of a bond or issuer, indicating the risk level to investors.

Ratings Implications

• Changes in credit ratings can affect bond pricing and investor perception.

• Investment Grade vs. Non-Investment Grade: Investment grade indicates lower risk relative to non-investment grade.

Bond Price Volatility

• Certain bonds exhibit greater price volatility due to market conditions and issuer factors.

Summary

• The market for fixed interest securities is utilized by both governments and corporations.

• Investors can choose from various fixed income investments with different risk levels and maturities (e.g., gilts, bonds, notes, debentures).

• A solid understanding of the various types of fixed interest instruments and their characteristics is crucial for informed investment decisions.

GILTS

The difference between the amount of money that the government spends and the amount of money that it collects in through taxes is known as the Public Sector Net Cash Requirement ‘PSNCR’. A significant proportion of this shortfall is funded through the issue of gilt-edged securities ‘gilts’.

A gilt, put very simply, is effectively a tradeable (securitised) IOU from the UK Government, acknowledging that the government owes the owner of the gilt, some money. In common with most situations when money is lent by one party to another, interest is payable on the borrowing and the borrowing has to be repaid. When we talk about gilts, the interest payment is described as the ‘coupon’ and the repayment of the borrowing is described as the redemption of the gilt. The amount repaid at

the redemption date is described as the ‘nominal value’.

THE FEATURES OF GILTS – DIFFERENT TYPES

The government issues two main types of gilts:

1- Conventional Gilts

These are the simplest type of gilt issued by the UK Government and comprise just over 75% of all the gilts that are in issue. They pay a fixed rate of interest (coupon), which is payable half yearly. On maturity, the owner of the gilt will receive the final coupon and the redemption value.

Convention in the market is to quote gilt prices as the price an investor has to pay to purchase £100 of nominal (redemption) value and is a ‘clean’ price excluding any accrued interest. Accrued interest is quoted separately as + or – a certain number of days. The current market price at the time the investor buys the gilt may be more than or less than £100.

If the current market price of a gilt is above £100, the gilt is described as trading ‘above par’ and the investor will make a capital loss on the gilt, when it is redeemed. If the current market price of the gilt is below £100, the gilt is described as trading ‘below par’. The investor will buy the gilt for less than £100 and will therefore make a capital gain when the gilt is redeemed at maturity.

Gilts are described in terms of the percentage coupon they pay and the maturity date, so a new gilt issued by the government paying a 4% coupon and maturing in 2016 would be described as: 4% Treasury Gilt 2016

The amount of coupon paid is the quoted percentage of the nominal value of the Gilt and not of the purchase price. An investor paying £95 for £100 nominal of gilt will therefore receive a coupon payment

of £4 per year (4% x £100), split into two equal instalments of £2 each.

Differently named gilts have been issued over the years. Recent issues have been named ‘Treasury Stock’ but previous issues have been named ‘Exchequer Stock’, ‘Conversion Stock’ ‘Consolidated Stock’ and ‘War. Although the name indicates the purpose or features of the original issue of the stock, there is now little practical significance in the name as they are all obligations which HM Treasury is liable to repay.

2 - Index-Linked Gilts

In addition to conventional gilts, the UK Government has, since 1981, been issuing index-linked gilts.

They now account for almost 25% of all the gilts in issue.

The quoted coupon is typically quite low, but is increased in line with how much inflation has increased over the time since the gilt was originally issued. The coupon payments are therefore ‘real’ rates of return and the income from these gilts is inflation proofed.

A similar process applies to the redemption value: this too is increased in line with how much inflation has increased since the gilt was issued, and protects the investor’s capital against inflation, although it is not growing in real terms.

To use the technical term, the coupon payments and redemption value are ‘up-lifted’. The measure of inflation used to calculate the uplifting is the Retail Prices Index ‘RPI’, not the Consumer Prices Index (CPI) which is now used as the Bank of England inflation target and is often quoted by the Government and media.

It would be logical for the inflation up-lifting to take account of the increase in inflation for the exact period from the date of issue to the date of payment of the coupon/redemption proceeds.

Unfortunately this is not the case. For gilts issued before 2005, the allowance for the inflation up-lifting is calculated with an eight months time lag. For those issued after 2005, a three-month time lag is used EXAMPLE CALCULATION:

Floating Rate Gilts

Although there are currently none in issue, the government has, in the past, issued some floating rate gilts, paying a variable coupon comprising a margin above (or below) a reference rate such as the London Inter-Bank Bid Rate (LIBID). The coupon payable is reset periodically in line with market rates.

With regard to the coupon, in the past there have also been issues where there are:

• floors – a minimum level of coupon that is paid;

• caps – a maximum level of coupon that is paid;

• collars – in which the coupon floats dependent on market rates between a floor and a cap.

The coupon payments on these gilts were paid quarterly, and as the coupon moves in line with market interest rates, they tend to trade close to par value.

ISSUES BY LOCAL AUTHORITIES

In addition to the central government raising finance through the issue of bonds, local government has the power to do the same.

In the past, local authorities issued bonds to raise money to finance the building of infrastructure in our cities. There is no legal constraint on local authorities still doing so, but it has been actively discouraged since the 1980’s when we started to see a much more centralised approach to economic control.

Since December 2004, Transport for London (itself designated as a local authority) has raised funds through the issue of local authority bonds, to finance improvements in the transport infrastructure.

The return on these instruments tends to be higher than that on gilts, as the risk is perceived to be higher. They are not government guaranteed in the same way as gilts.

The types of bond that local authorities can issue include the following:

• Yearlings – These are short-term debt instruments issued with maturities of either one or two years, issued in minimum denominations of £1000 nominal.

• Local Authority Stocks – This is very similar to a gilt, in that it is a longer-term bond, paying a fixed coupon semi-annually.

• Fixed Loans/Local Authority Mortgages – These instruments are known as local authority bonds or mortgages, and are issued for a set term during which the local authority pays the holder interest. Terms typically range from one – six years and rates vary depending on the issuing authority. They constitute a lump sum investment where no additions or withdrawals are allowed, and the capital is repaid at the end of the term.

REDEMPTION DATES AND THE USE OF SINKING

FUNDS

Most gilts have a specified redemption date. Some, however, are different in style.

Double-Dated Gilts

In the past, the government has issued double-dated gilts, for instance 7 ¾% Treasury Loan 2012-15. There are currently only two left in issue. The government can choose to redeem these gilts on any day between the first and final maturity dates, providing it gives at least three months notice.

When it chooses to redeem, will depend on whether these gilts represent cheap or expensive borrowing for the government. If rates are lower in the market place when 2012 arrives, the likelihood is that the government will redeem the gilt at the earliest opportunity because it can re-borrow the money at lower rates. If rates are higher in the markets, the government is likely to redeem the gilts at the latest possible date.

Undated Gilts

There are also a small number of undated gilts in issue, some of which date back as far as the nineteenth century. Technically the redemption of these bonds is at the government’s discretion, after a specified date, which has long since gone. Given they were issued at very low coupons, there is little incentive for the government to redeem them.

Sinking Funds

A sinking fund makes a provision for the repayment of the capital outstanding under a bond, and therefore reduces the default risk of the bond.

They usually work in one of two ways:

• A counterpart fund can be established, where the issuer of the bond puts money aside each year in readiness for redemption.

• Alternatively, the issuer may repay a set proportion of the bond at set intervals. For example, 1/15th of a bond’s issue may be redeemed every year for fifteen years.

The method of selecting the bonds to be redeemed will be specified in the terms of issue, and may be by way of lottery, whereby serial numbers of the bonds to be redeemed, are ‘drawn’ at random. If, however, it is agreed in the terms of issue that the bonds will be redeemed at par and the bonds are trading at less than par value in the markets, the issuer may choose to purchase bonds in the market with a total par value equal to the amount that is to be redeemed.

There is usually a period during the initial life of a bond, where the sinking fund does not operate. In the example above for instance, the bond may be a twenty-year issue with no redemptions during the first five years, and 1/15th of the bond is redeemed annually thereafter.

The existence of a sinking fund may reduce the risk associated with a particular bond.

GILT PRICING AND ACCRUED INTEREST

We have seen so far, that gilts are priced per £100 of nominal or redemption value, but the gilts market also adopts a ‘clean’ and ‘dirty’ pricing system.

If an investor wishes to buy a gilt, they will be quoted the clean price. The clean price is the price that is quoted in the financial press.

When they actually come to pay for the gilt, they will pay the ‘dirty’ price. This comprises the clean price plus an allowance for accrued interest. For the majority of time that gilts are traded, the dirty price will be more than the clean price.

This is how it works:

Seven business days before the coupon payment is due, the identity of the registered owner of the gilt is established, and the coupon payment for the whole half-year is paid to that investor on the coupon payment date.

The owner of a gilt, who sells it between coupon payments, will be entitled to interest which will be paid to the new holder on the next coupon date. When buying a gilt, the purchaser must therefore compensate the seller for the interest that was accrued during the seller’s period of ownership.

The clean price plus (or minus) the accrued interest, makes up the dirty price.

During the cum-div trading period, the accrued interest is added to the clean price to compensate the seller for the interest accrued, which will be paid to the new holder.

During the ex-div period, the accrued interest is deducted from the clean price to make up the dirty price. If a gilt is sold during this period, the purchaser will have owned the gilt for a few days before the coupon payment is made. As such, they will be entitled to the accrued interest for the number of days that they owned the gilt, before the coupon payment date. As the coupon for the whole half-year will be paid to the seller, the seller must rebate the purchaser the accrued interest that the purchaser is entitled to.

The purchaser therefore pays the clean price for the gilt, with the value of the accrued interest owed to him by the previous owner, deducted from the cost.