How do UK Gilts interest rates and repayments work?

Question

I'm looking at UK Gilts and trying to understand how the interest rates and repayments really work. As I understand, if I buy £100 of a "5% Treasury Gilt 2020" it means I will get 5% interest each year (so £5), plus the £100 back 4 years later.

This is simple enough, however when I look at the available stock, the numbers don't seem to make sense.

For example these two stocks are both available:

• 1.25% Treasury Gilt 2018
• 5% Treasury Gilt 2018

Why are they both available and why would one choose 1.25% over 5%?

There's also a "8.75% Treasury Stock 2017", which seems incredibly high for such a short maturity. Am I missing something?

Answer 1

A title such as "5% Treasury Gilt 2020" expresses the nominal yield. In other words, 5% is the yield you will receive if you are able to buy the Gilt at the nominal (issue) price of GBP100.

Of course, you will not be able to buy such a Gilt in today's market for the nominal price of GBP100. It will be trading at a considerable premium and therefore, if you hold it until maturity you will realise a capital loss to offset the relatively high income you have received.

Here is an example. The "8% June 2021 Gilt" has a coupon of 8%. To purchase a GBP100 nominal Gilt in today's market will cost you GBP135.89. Thus, you will pay 135.89 to receive GBP8.00 income annually. This represents a 5.88% yield (8/135.89 = 5.88%). That sounds pretty good. However, if you hold the Gilt until maturity you will only receive GBP100 on redemption and therefore you will experience a capital loss GBP35.89 on each Gilt purchased. When this capital loss is taken into account it means that the 5.88% yield you are receiving as income will be offset by the capital loss so that you have earned the equivalent of 0.757% annually. You can of course sell the Gilt before its 2021 maturity date, however as the maturity date gets closer the market price will get closer to the GBP100 nominal value and you will again face a capital loss. There's no free ride in the markets. 5 year Gilts currently have a redemption yield of about 0.75%, while 10 year Gilts currently have a redemption yield of about 1.15%.

You may also wish to note that buying Gilts in the open market requires a minimum purchase of GBP10,000 nominal value. However, you can purchase small Gilt holdings through the post office.

Answer 2

The name of the Gilt states the redemption date, but not the original issue date. A gilt with 8.75% yield and close to its redemption date may have been issued at a time when interest rates were indeed close to 8.75%. For example in the early 1990s, the UK inflation rate was about 8%.

One reason for preferring high or low coupon gilts is the trade off between capital gains and income, and the different taxation rules for each. If you buy a gilt and hold it to its maturity date, you know in advance the exact price that it will be redeemed for (i.e. £100). You may prefer to take a high level of income now, knowing you will make a capital loss in future (which might offset some other predictable capital gain for tax purposes) or you may prefer not to take income that you don't need right now, and instead get a guaranteed capital gain in future (for example, when you plan to retire from work).

Also, you can use the change in the market value of gilts as a gamble or a hedge against your expectation of interest rate changes in future, with the "government guaranteed" fallback position that if your predictions are wrong, you know exactly what return you will get if you hold the gilts to maturity. The same idea applies to other bond investments - but without the government guarantee, of course.