Government stock, or gilts as they are better known, are effectively bonds issued by the UK Government and are listed on the London Stock Exchange. The term 'gilt' or 'gilt-edged security' refers to the main characteristic of these bonds as an investment, i.e. their security. As the UK Government has never failed to make the interest or principal payments on gilts as they fall due, they are viewed as a safe and low risk investment.
The gilt market consists of broadly two different types of securities, namely conventional gilts and index-linked gilts. Conventional gilts form the largest part of the gilt market and guarantee to pay the holder a fixed cash payment (coupon) every six months until the maturity date, at which point the holder receives the final coupon payment and the return of the principal.
Conventional gilts have their own coupon rate and maturity date. The coupon rate normally reflects the market interest rate at the time of the first issue of that particular gilt. As a consequence, there is a wide range of coupon rates available in the market at any one time and this reflects historic fluctuations in interest rates.
Index-linked gilts are similar to conventional gilts in that the coupon again reflects the borrowing rates available at the time of first issue. However, the main difference is that index-linked coupons reflect the real borrowing rate for the Government rather than the nominal borrowing rate and there is, therefore, a much smaller variation in real yields over time. As a consequence, the semi-annual coupon payments and the principal are adjusted to take into account accrued inflation, as measured by the UK Retail Prices Index, since the gilt was first issued.
Looking at conventional gilts in particular, 2008 proved to be a very strong year in terms of performance when compared to other asset classes and especially in relation to the broader credit markets. As last year wore on and global economic data worsened while concerns over the health of the banking sector increased, investors became increasingly risk averse and sought the perceived safe haven of gilts. Furthermore, the credit markets saw widening spreads compared to gilts as the collapse of Lehman Brothers in particular further increased risk aversion. Gilts also benefited from pension funds continuing to switch out of equities in favour of gilts as they looked to both close their deficits and to match future liabilities.
The above factors have combined to drive gilt prices higher and yields sharply lower. This leads to the question of whether there is a bubble forming in the gilt market and what will happen during 2009. Firstly, it is important to remember that the UK Government is about to embark on a massive new issuance of gilts totaling approximately £146 billion in order to fund its huge borrowing requirement. However, while there are concerns that this significant increase in supply would have a negative impact on prices, this has yet to happen. Pension fund buying is likely to take up some of this increased supply while banks may also be forced into vast acquisitions of gilts in order to meet new liquidity rules. In addition, there is the possibility that the authorities may soon purchase gilts as part of a policy of 'quantitative easing'.
Fears of deflation in the UK also increase the attractiveness of gilts as a result of the lower yields that are available. The returns from cash held on deposit if interest rates fall further will be almost next to nothing.
In summary, there does still appear to be a short-term case for gilts with the likelihood of lower interest rates, concerns remaining over deflation, high levels of volatility continuing in riskier asset classes such as equities and lower returns from cash all combining to support prices. However, any change in the economic climate or increase in investor risk appetite could lead to a sharp reversal in gilt prices while if demand does not match the increased supply, this may also send yields higher. Both arguments do, however, reinforce Origen's view that a diversified asset allocation, including an exposure to gilts when appropriate, may help provide better risk-adjusted returns as portfolios are better positioned to take advantage of different market conditions and varying performance from each asset class.
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