The government needs an efficient market in its own longer-term debt: this is the part of the stockmarket known as the gilt-edged market which we touched on briefly in Chapter 1. ‘Gilt-edged stocks’ or ‘gilts’ is simply the term used for British government bonds or government stocks, which are so called because they represent the absolute peak of quality and security. The government’s agent in this market used to be the Bank of England but responsibility has passed to the UK Debt Management Office (DMO), which is now an executive agency of the Treasury. The DMO advises on debt issues and organizes the auctions of gilts on behalf of HM Treasury. The registration, servicing and redemption of government stocks is still carried out by the Bank of England’s Registrar’s Department. Settlement of gilt-edged transactions is due to move in the course of the year 2000 to the CREST electronic system (see Chapter 6). In 1999 the total turnover of gilt-edged stocks was £1,692 billion (about 36 per cent representing trades between marketmakers rather than with customers) and the total value of all stocks listed was some £333 billion at the end of that year.
New issues during the year totalled some £14.6 billion at market values, as new stocks were created to replace those that matured. But in effect the government was in the happy position of being a net repayer of debt in 1999, as redemptions of existing stocks at £18.8 billion comfortably exceeeded new issues. This was in marked contrast with most periods in the past. In the recession of the early 1990s the government’s income from taxes and other sources fell while its spending on unemployment benefits and other items rose sharply. In 1993 it borrowed some £51 billion net via the issue of gilt-edged securities.
The high turnover in the gilt-edged market relative to the value of the stocks listed partly reflects massive and frequent switching from one stock to another, when a particular stock appears to offer a small interest rate or tax advantage to a particular class of holder. And recent changes to the structure of the market (see below) could make it still more liquid in the future.
Figure 13.1 Net issues of government securities (£m) This chart reflects the big variations in the government’s borrowing needs. In the early 1990s borrowing was rising sharply during the recession on account of flat tax revenues and high social security spending on unemployment benefits and the like. By the end of the decade the benefits of a healthier economy had fed through. The government was actually repaying more gilt-edged stocks than it was issuing and investors faced a shortage of stock to invest in. Source: Office for National Statistics: Financial Statistics.
Press coverage of the gilt-edged market is far more restricted than equity market comment. Except for comment of a highly technical nature, there is far less to say. There are no takeover battles. There are no profit announcements affecting individual stocks. The main news that moves the gilt-edged market is news of Britain’s economic and financial outlook, boiled down to a view of likely movements in interest rates and inflation. Estimates of the government’s borrowing needs, influencing the volume of gilts to be issued in future, and movements in government bond prices in overseas markets also play their part. Individual news items may affect one sector of the gilt-edged market more than another (see below) but comment on price movements in individual stocks is comparatively rare. This is also true of comment on the bonds issued by industrial and commercial companies, which operate in a similar way to government bonds and much of the explanation in this chapter applies to company bonds as well: certainly the basic price mechanism. But a few additional factors affect company bonds and these will be examined towards the end of the chapter.
Given the limited number of influences on the gilt-edged market, the press comment falls into three main categories. There are occasional pieces on the outlook for the fixed-interest market as a whole, usually sparked off by events that could mark a turning point. There are pieces on the DMO’s intentions and techniques in its handling of the market. And there are the regular but brief reports of price movements of government stocks and fixed-interest bonds in general, plus the reasons for them, amplified where appropriate by news of new issues or changes in the DMO’s issue techniques.
If you remember the basic mechanism described in Chapter 1 – when interest rates go up, prices of fixed-interest stocks come down and when interest rates come down prices of fixed-interest stocks go up – much of this comment falls into place. Weakness in sterling generally rattles the gilt-edged market because it is feared that interest rates may have to rise or stay high to defend the pound. Domestically, fears of higher inflation, caused by overheating in the economy, or excessive earnings growth bring fears of higher interest rates. On the other hand, if sterling is strong and the inflation outlook is improving, lower interest rates might be expected and the prices of gilt-edged stocks could be expected to rise.
However, different factors affect different sectors of the gilt-edged market. Should the government need to defend the currency by raising short-term interest rates (which immediately affects the cost of borrowing money from the banks) the effect will probably be most marked on the yields expected from government bonds that have a short life to run (see below). This is because a bond with only, say, a year or two years of life before it is repaid has much in common with a bank deposit and the returns on the two different types of investment will influence each other strongly. On the other hand, when investors look at the returns on bonds with a longer life – say, ten years before they are repaid – they will probably pay more attention to evidence about inflationary trends in the coming years. This is because they are interested in the real return that the bonds offer over their life (the return after allowing for inflation). If evidence emerges to suggest that inflationary pressures will be higher than expected over the coming years, the markets expect that long-term returns will have to rise to compensate investors for the higher inflation, or alternatively that interest rates will need to be higher to restrain inflation. All else being equal, this means that the prices of existing longer-dated, fixed-interest bonds must drop until they provide the returns that investors now expect.
Remember that it is vital for investors to spot evidence of a change in expectations of inflation or interest rates. The overall returns can be very high for those who buy gilt-edged stocks just ahead of a major turning point when interest rates are about to move sharply down. This happened again in the recent past and a buyer of certain gilt-edged stocks in 1997 could have seen a return over more than 50 per cent in an 18-month period.
The market is also affected by more technical factors. If a large amount of new stock is being brought to the market it may depress prices, because for a time the supply of stock will outpace investors’ readiness to buy, though the DMO’s methods of selling stock are intended to minimize the effect. A heavy flow of non-gilt sterling bond issues by companies and others may influence the market for government bonds. One other technical aspect of the market is now frequently remarked: investors have the opportunity to take a bet on movements in gilt-edged prices by buying or selling financial futures contracts in gilt-edged securities (see Chapter 18). Price movements in the very sensitive financial futures market can thus herald trends in the gilt-edged market itself, often referred to as the cash market when contrasted with the futures market.
To understand the more detailed comment, we need to look a little closer at the structure of the market.
While the terms gilt-edged market and fixed-interest market are sometimes used almost interchangeably, they are not always quite the same thing. Not all government stocks carry a fixed rate of interest, though the vast majority of them do. And not all fixed interest stocks are government stocks. There are loans issued by industrial and financial companies (corporate bonds, industrial loans, corporate loans or debentures), loans issued by local government bodies (corporation loans) and loans issued in sterling by foreigners on the UK market (bulldog bonds). There are also the convertible stocks issued by companies, which were discussed in Chapter 5. Measured by the amount in issue, British government stocks predominate, but bonds issued by companies are also significant.
Most gilt-edged securities are redeemable: the government will repay the stock at some point, but there are a few that have no fixed date for repayment. The notorious War Loan is probably the most familiar of these undated or irredeemable stocks. Irredeemable stocks have a value, because the right to receive interest each year has a value. But investors in these stocks who want their capital back can obtain it only by selling the stocks to other investors.
Figure 13.2 The fall in bond yields as inflation came under control How longer-term yields have come down in Britain since the high-inflation days. The chart shows the yield on a 10-year government bond and reflects in part the declining influence of fears of inflation as the 1990s progressed. Companies pay a little more than the government when they borrow via bond issues, but it is clear that their long-term borrowing costs have come down dramatically. It is not all good news, however. Lower long-term bond yields mean that pensioners’ savings buy a lower income in retirement. Source: Datastream.
The dated fixed-interest stocks are subdivided according to their life or maturity: how long they have to run until they are repaid. Those with a life of less than seven years (opinions vary – the Financial Times chooses five years) are classified as shorts, those with lives of seven to 15 years as medium-dated and stocks with more than 15 years to run as longs. These classifications reflect the current life of the stock, not its life when issued. A 25-year stock issued in 1987 – therefore repayable in the year 2012 – would initially have been in the ‘long’ category, but by 1999 it would have had a remaining life of under 15 years and would have been classified as a ‘medium’. You will see how stocks are classified according to redemption date under the heading of ‘UK Gilts Prices’ in the ‘Companies & Markets’ section of the Financial Times.
If you had been looking at UK gilts prices in 1999 you would also have seen that prices quoted for conventional fixed-interest stocks were mainly in a range between about 100 and 140. Though the pound signs are omitted, these are the prices in pounds and decimals of pounds for a nominal £100 of the stock (the market traditionally used fractions such as 32nds of a pound, but decimals have now taken over). In practice the prices quoted are middle prices, between the buying and selling prices that marketmakers normally quote. Prices and interest rates are, as we saw earlier, expressed in terms of this nominal £100 unit of stock, though it does not mean that buyers or sellers have to deal in round amounts of £100 nominal. But a 6 per cent stock pays £6 of interest on every £100 of nominal value and the stock is normally repaid at this £100 nominal or par value at redemption. It was noticeable that, in 1999, almost all redeemable stocks were standing above their par value of 100 in the market. This is by no means always the case, but will happen when a period of lower long-term interest rates follows a period of high ones.
The wide range of interest rates or coupons on the different stocks – ranging from under 3 per cent to over 13¾ A per cent in 1999 – gives some indication of the interest rate the government had to pay when they were first issued and hence the very large movements in interest rates over the years. It is not a perfect guide, since stocks are often issued somewhat above or below their £100 par value (at a premium or at a discount) so that the yield to a buyer even at the outset is significantly different from the coupon rate.
You will also see from the Financial Times that stocks have somewhat curious names such as Treasury, Exchequer and Funding. Nowadays, ‘Treasury’ or ‘Exchequer’ is chosen as circumstances dictate to help identification if there are stocks of similar coupon maturing in the same year – ‘Exchequer’ is chosen if there is already a similar ‘Treasury’ stock. The word ‘Loan’ in the title indicates that the stock can be held in bearer form.
Regardless of the name, all the money raised goes into a central pool. What is important is the interest rate and the redemption date, which follow the name of the stock. Where two redemption dates are shown, the stock will not be redeemed before the first date and must be redeemed by the second. Thus, Treasury 5½ per cent 2008–2012 pays £5.50 a year on every £100 nominal of stock (carries a 5½ per cent coupon) and is due to be repaid (at the government’s option) at the earliest in 2008 and the latest in 2012. Treasury 8 per cent 2013 carries an 8 per cent coupon and will be repaid in the year 2013.
But the interest rate or coupon is not the yield that a buyer of the stock receives, unless he happens to buy the stock at its par value of £100. The yield to the investor depends on the price of the stock in the market. And since it is easier to illustrate the principle with a stock that is standing below its par value, we will invent a convenient one. Let us call it Imaginary Treasury 3.5 per cent 2009 and assume that late in 1999 its price in the market was 90.
Thus, a buyer of the stock in 1999 would have been paying only about £90 to acquire stock with a nominal value of £100 and paying an income of £3.50 a year. A £3.50 income for an outlay of £90 represents a yield of 3.89 per cent on the outlay.
This is known as the interest yield, income yield, flat yield or the running yield. To calculate an income yield, you need to express the annual income as a percentage of the price the investor would have to pay. The sum to calculate an income yield is therefore simply:
giving the answer of 3.89 per cent.
If Imaginary Treasury 3.5 per cent were an undated stock, this would be the end of the matter. But it is to be repaid at its nominal £100 value in 2009. Thus a buyer in 1999 could say to himself ‘I’m paying about £90 for a stock that will be repaid to me at £100 if I hang on to it till 2009. In other words, I’ll see a £10 capital profit in 2009, in addition to the income I’ve been getting. This £10 is really part of the total return I’ll get on the stock if I hold on to it. If I apportion the £10 over the ten years that the stock has to run, it works out at £1 a year. So notionally I’m getting an extra £1 per year for my outlay of £90, which is about 1.11 per cent. This is my gain to redemption. If I add it to the 3.89 per cent yield I’m getting from the income, I have a notional combined yield of 5 per cent.’
In practice, an investor who did his sums this way would have grasped the general principle, but would be wrong on the detail. To calculate the total return requires a compound interest sum and is best done with a computer program or a sophisticated calculator. But he is right inasmuch as the Financial Times quotes two yields for each dated gilt-edged stock. First the interest yield, then the redemption yield, which combines the interest yield with the notional gain to redemption or loss to redemption (see below). When Imaginary Treasury 3.5 per cent 2009 at a price of 90 was showing an income yield of 3.89 per cent, in practice it would have given a redemption yield of about 4.78 per cent.
It is probably easiest to grasp the principles of fixed-interest stocks by taking – as we have done – a stock which stands in the market below its par value of £100 and where there is therefore a gain to redemption for the investor. What has happened here is that the stock was probably originally issued at a period of very low interest rates when investors would have expected a return of only 3.5 per cent. Even after some very sharp reductions from the considerably higher interest rates prevailing in the intervening years, by 1999 investors still expected a yield of more than 3.5 per cent on a ten-year bond. So they would not buy our Imaginary Treasury 3.5 per cent 2009 unless the price was down at a level that would show them a return on their outlay in line with what they could get on comparable stocks: we have taken about 4.8 per cent for purposes of illustration.
Example 13.1 Price Information on UK government bonds. Source: Financial Times.
But, as we saw, in 1999 the majority of government stocks were standing above 100. The picture here is the reverse. The stocks were issued with high coupons at a time when interest rates were high. As the yields that investors can expect came down, they were prepared to pay more than the £100 nominal value for the stock. Where this is the case the buyer will, of course, register a capital loss rather than a gain when the stock is repaid at only £100 and in this case the redemption yield will be lower than the income yield. The income the investor receives over the years has to be high enough to compensate for this capital loss on redemption.
Take an example. Late in 1999, Treasury 9 per cent 2012 stood in the market at 134.22. It offered an interest yield as high as 6.57 per cent but a redemption yield of only 5.03 per cent when account was taken of the loss to the investor when it was redeemed at only 100 in the year 2012.
Trading between one gilt-edged stock and another is often driven by considerations of tax. And the position is now a bit complex. Broadly, private investors pay tax on the income or notional income from a gilt-edged stock but pay no tax on capital gains (correspondingly, they cannot offset capital losses against gains elsewhere). Corporate investors, on the other hand, pay tax on the total return, regardless of whether it comes in the form of income or capital gain. Pension funds, of course, do not pay tax on income or capital gains, since they are tax-exempt.
This means that the difference between income yield and redemption yield is very important to investors (though slightly less so than when the highest income tax rates were well above 1999’s 40 per cent). Let us look at it from the point of view of a private investor who pays top tax of 40 per cent and keeps only 60p of every £1 of income that he receives, but keeps £1 of every £1 of capital gain that he makes. Look again at Treasury 9 per cent 2012, quoted in the market at a price of 134.22. An investor is getting 6.57 per cent of income but suffering a notional 1.54 per cent loss to redemption to provide the combined 5.03 per cent redemption yield. To a private investor paying 40 per cent tax, the tax liability affects his return as shown in Table 13.1:
|
Net of tax |
|
|
% |
% |
Income yield |
6.57 |
3.94 |
Gain (loss) to redemption |
(1.54) |
(1.54) (no tax) |
Total return |
5.03 |
2.40 |
Table 13.1
So the net return is 2.40 per cent. Now look at another stock, Treasury 5¾ per cent 2009, which was standing in the market at 105.04 at the same time to give an interest yield of 5.47 per cent and a redemption yield of 5.10 per cent (see Table 13.2).
|
Gross |
Net of tax |
|
% |
% |
Income yield |
5.47 |
3.28 |
Gain (loss) to redemption |
(0.37) |
(0.37) (no tax) |
Total return |
5.10 |
2.91 |
Table 13.2
The redemption yield on the 5¾ per cent stock is only marginally higher at 5.10 per cent than the 5.03 per cent obtainable on the 9 per cent stock. But the after-tax return to the private investor is significantly higher at 2.91 per cent than the 2.4 per cent he would get on the 9 per cent stock. This is because a smaller proportion of the return on the 5¾ per cent stock comes in the form of taxed income. The examples underline an important aspect of the gilt-edged market. No one government stock is quite like another. Different stocks are worth different amounts to different classes of investor.
Remember, however, that redemption yields of any kind are, to an extent, notional. The redemption yield is relevant to the investor if he holds the stock to redemption. In the interim its price will be determined by the interplay of buyers and sellers, though on balance it will obviously move closer to 100 as the redemption date approaches. This is known as the pull to redemption. But the redemption yield is the main yardstick for comparing one stock with another and for calculating the likely price a borrower would have to pay for raising money via a bond issue at a given time.
One more example will help to explain prices in the gilt-edged market (and other forms of bond market) and it will be easier again if we invent a theoretical case rather than taking actual stocks. Suppose that in 1999 the government had decided to issue three different stocks. One was short-dated with a life of only three years, one was medium-dated with a life of ten years and one was a ‘long’ with a life of 25 years. Suppose also that the government reckoned, given the structure of interest rates at the time, that it would have to offer investors a redemption yield of 4.5 per cent on each of the stocks to persuade investors to buy them (we have taken this figure for convenience, not as an indication of the precise interest rates at the time). Each stock was therefore issued at its par value of 100 with a 4.5 per cent coupon.
Now, these assumptions are, of course, a little unrealistic. It is very unlikely that the yields investors expected would have been exactly the same for a short-dated stock, a medium-dated one and a very long-dated stock. But they serve to illustrate our point. So we have our three stocks which we will give the names shown in Table 13.3:
|
Price |
Income Yield |
Redemption Yield |
|
|
% |
% |
Short-dated 4.5% 2002 |
100 |
4.5 |
4.5 |
Medium-dated 4.5% 2009 |
100 |
4.5 |
4.5 |
Long-dated 4.5% 2024 |
100 |
4.5 |
4.5 |
Table 13.3
With each of the stocks at a price of 100, income yields and redemption yields are exactly the same because there would at this point be no gain or loss to the investor on redemption.
Now suppose that a year later things have deteriorated in the UK economy. There is evidence of higher inflation in the pipeline and investors demand higher yields to compensate. If the government issued a new gilt-edged stock at this point it would have to offer a yield of, say, 6 per cent to persuade investors to buy. What happens to the market prices of our three stocks issued in 1999? The answer is clearly that no investor would buy them at a price of 100 where the redemption yield is only 4.5 per cent. The prices of the stocks will have to fall in the market until they reach a level where investors would buy them. What would this level be? It is the price at which they will offer the 6 per cent redemption yield that investors now expect. Again, we are being slightly unrealistic because it is doubtful if investors would expect exactly the same redemption yield from three stocks with different lives and different tax characteristics. But, to illustrate our point, the position would be as shown in Table 13.4 if each stock now had to offer a redemption yield of 6 per cent (remember that the remaining life of each stock is now a year shorter than when they were issued in 1999):
|
Price |
Income Yield |
Redemption Yield |
|
|
% |
% |
Short-dated 4.5% 2002 |
97.25 |
4.63 |
6.00 |
Medium-dated 4.5% 2009 |
89.80 |
5.01 |
6.00 |
Long-dated 4.5% 2024 |
81.20 |
5.54 |
6.00 |
Table 13.4
The example shows very clearly that long-dated stocks show much larger price movements for a given change in interest rates than short-dated ones. An investor in the short-dated stock who had bought at 100 originally and now needed to sell would have lost some money but not a massive amount. The investor in the medium-dated stock would have lost quite heavily and the investor in the long-dated stock would have fared worst of all. Investors in all three stocks would eventually be repaid at 100 if they hung on for redemption, but in the meantime the losses could be substantial. Thus, investors who are averse to risk and might want to get their money back in a hurry are more likely to buy the short-dated stocks. Those who want to tie their money up for a long time at a known return, together with the more adventurous or those who want to take a deliberate bet on favourable movements in interest rates are more likely to go for the long-dated stocks.
The pull to redemption is much greater with a short-dated stock than a long-dated one. When a stock is due to be repaid at £100 in the fairly near future, redemption is the dominant influence and its price will not fluctuate so widely in response to movements in interest rates. Nor, as the example shows, does it need to do so to accommodate investor’s changed expectations of the return they should get. It is true that short-term interest rates can nowadays fluctuate very widely (perhaps by more than long yields), and will affect short-dated stocks more than the long-dated ones. Thus, as our example shows, price fluctuations can be quite marked even at the short end of the market. But the risk of capital loss is still a great deal lower than with long-dated stocks. Market reports will often highlight the different magnitude of price movements at the long and short end of the market. Investors switch between stocks of different maturities according to the way they expect long-term and short-term interest rates to move.
Interest on most gilt-edged securities is paid twice a year. So between dividend payments it is accruing–building up – until the moment it is paid. Prices for gilts are now quoted clean (they exclude accrued income). But a buyer normally pays for (and receives the right to) any income that has accrued since the last dividend date, in addition to the price he pays for the stock itself. However, if he buys it once the stock has gone ex-dividend (see Chapter 4), the seller keeps the right to the forthcoming interest payment. Since the date that a stock goes ex-dividend does not correspond exactly with the end of an interest period, the seller pays the buyer rebate interest in respect of the period for which the buyer will hold a stock but the seller will receive the interest from the government. Yields on gilt-edged stocks are always calculated on clean prices. If the tax laws permitted (see below), it would benefit some higher-rate taxpayers to buy a stock just after it had gone ex-dividend and sell it shortly before the next dividend payment was due. In this way they receive no income, on which high rates of tax would be payable, but receive the benefit in the form of untaxed capital gain.
This practice, known as dividend stripping, has now been outlawed and the interest is normally taxed as income whether in fact it is received as interest or as capital gain. However, an exception is made for investors whose gilt-edged holdings total less than £5,000 at nominal values. These are taxed on an ‘income received’ basis.
The fact that interest on most UK government stocks is paid in two equal six-monthly instalments (paid semi-annually) introduces a slight complication when comparing gilts with bonds that pay interest as a single sum at the end of the year. The interest received after the first six months may itself be invested to earn interest for the second half of the year. Suppose an investor bought a gilt with a coupon of 5 per cent at its nominal value of 100. After six months he receives interest of £2.50 and may reinvest this at, say, the same 5 per cent rate to earn interest of 6.25p in the second six months. The total interest he receives over the year is therefore £5.0625, not £5, and the 5 per cent coupon on the bond is really worth 5.0625 per cent if compared with a bond paying interest as a single annual sum (see also Chapter 17).
So far we’ve been talking of fixed-interest stocks. But there are, and have been, other types of government stock. For example, in 1996 a floating rate gilt was issued which was due to mature in 2001. The return to the investor varies with movements in interest rates in the economy.
There are also the index-linked stocks, which provide protection against inflation (act as an inflation hedge). They were initially introduced in 1981 for the pension funds, then made available to any type of investor – they now account for some 20 per cent of the gilt portfolio. With an index-linked stock, both the income and the price at which it will be redeemed are adjusted to take account of the movement in retail prices. In other words, both income and capital retain their real value. The price you pay for this protection is a much lower nominal coupon rate.
Say an index-linked stock is issued at its par value of 100, with a coupon of 2.5 per cent. Over the next five years, retail prices rise by 30 per cent in total, meaning that it would cost you £130 to buy goods and services you could have obtained for £100 five years earlier. So the price at which the stock will be redeemed rises to 130. The interest it pays must also rise by 30 per cent to maintain a real interest rate of 2.5 per cent. So the interest rate after five years will be 2.5 per cent on the new £130 redemption value (equivalent to 3.25 per cent on the original £100 nominal value).
Of course, if retail prices were to fall in year six, the redemption value could be adjusted down again from 130 and so could the interest. But in the more likely event that retail prices continue rising (though at different rates in different climates) the redemption value of the stock will continue to rise.
In practice, the redemption value of an index-linked stock does not match the movement in retail prices (as measured by the retail prices index or RPI) quite as closely as in the example because there is a time lag of eight months built in so that the size of the interest payment is known before the start of the interest period. This means that the return from the last eight months of the life of the gilt is not indexed and the real return will therefore vary depending on the future rate of inflation. In compensation, the investor is recompensed for inflation in the eight months before the stock was issued. The Financial Times quotes two possible real redemption yields, one on the assumption of 5 per cent inflation and the other on the assumption of 3 per cent (it is a measure of how much inflationary expectations have come down in recent years that these figures used to be 10 per cent and 5 per cent). The Financial Times also shows (in brackets after the name of each index-linked stock) the starting point for the indexation sum on the retail prices index or RPI.
The market price of the index-linked stock is, as with a fixed-interest stock, not directly determined by the redemption value, though this will begin to exert more influence as redemption comes close. Real redemption yields are very low (mostly in the region of 2 per cent late in 1999), partially reflecting the fact that most of the return comes in the form of untaxed capital appreciation. Index-linked stocks are not at their most attractive when real rates of return on conventional gilt-edged are high: in other words, when the nominal yields are well above the inflation rate. Index-linked stocks are more popular when inflation-fears rise.
Price movements in the fixed interest market are measured on a number of indices. Separate FTSE Actuaries indices are published for a number of different maturity ranges of gilt-edged stocks, as well as for the irredeemables. There is also an All Stocks Index for gilt-edged as a whole. There are separate indices for index-linked stocks, again covering a range of different maturities, and there is a further index for index-linked stocks as a whole. The Financial Times also publishes its own longer-established Government Securities Index with a base of 100 in 1926. Market reports talk of price movements of a point or fraction of a point in individual stocks: a point in this context is one pound per £100 nominal.
The mechanics of issue and subsequent dealing for gilt-edged stocks, as with equities, underwent some changes with the Big Bang. And in the second half of the 1990s further changes were made in the interests of a more efficient market and greater competitiveness with government bond markets overseas (see below).
In the past, when a public offering of stock was made, a minimum price was usually set and tenders were invited at or above that figure. All accepted bidders at tender paid a common price. The price might be due as a single payment, or payment might be made in instalments (see Chapter 8 for a description of partly paid stocks in the equity market, where the procedure is similar).
Stock that did not find buyers at a tender remained in the hands of the government and was subsequently made available to the market as and when there was a demand for it and when it suited the authorities to make further sales. Stock available for issue in this way is described as a tap stock because the supply can be turned on and off as required. A second source of stock that can be used as a tap is issues of small tranchettes of stock – possibly of a range of different stocks – which are available for sale to the market in the same way. Sales of tap stocks to the market are made via the DMO’s dealing room, but they have become rarer since auctions for index-linked stocks were introduced (see below).
No issues of stock via the tender method have been made since 1991 and the more recent auction method is now the norm. This was first introduced in 1987 when the Bank undertook an experimental series of auctions for selling large amounts of stock, initially as a supplement to the tender method. The main difference between the auction and the tender is the implication, in the auction method, that there is the intention to sell all the stock on offer. Also, competitive bidders for conventional stocks are allocated stock at the price at which they bid, rather than at a common striking price as in a tender (see Chapter 8 for a description of the tender mechanism). But for small bids the facility exists for stock to be allocated non-competitively at the average of the accepted competitive bids. In the case of index-linked gilts, stock is allocated at the average price offered by successful bidders.
New gilt-edged stocks are created to satisfy the government’s financing needs and the market’s need for a balance of short, medium and long dates and index-linked stocks. The gilt auction operations by the DMO now take place according to a calendar determined a year in advance, with an indication of the identity of the stocks to be auctioned being given in advance of each quarter. The nominal size is announced in the week before an auction.
At times when the government is a net repurchaser of stock, one option open to the authorities would be to hold reverse auctions under which holders can offer to sell stock back to the authorities, who accept the stock offered at the most favourable price. As with the ordinary auction, there would also be facilities for small offers of stock.
Before Big Bang, gilt-edged stocks – once issued – were traded on the stockmarket via the jobber/broker mechanism as with equities. Nowadays the marketmaking function is undertaken by primary dealers known as gilt-edged marketmakers or GEMMs, of which there were 16 operating in 1999. They include former gilt jobbing and broking firms but also offshoots of banks and other financial institutions including a number of American, Japanese and continental European firms. These primary dealers have an obligation to maintain a market in all government stocks and have the right to deal direct with the Bank of England. They can bid for available tap stocks when they wish.
The market mechanism is eased by inter-dealer brokers, via whom the gilt-edged marketmakers can effectively deal with each other without disclosing their positions to their competitors. The primary dealers have access to a price information system via the SEAQ screens, but this is more rudimentary than the SEAQ equity service and they rely more heavily on screen-based price information supplied by the inter-dealer brokers. In order to cover their short positions, marketmakers can also borrow (rather than buy) stock from stock exchange money brokers, who have increased in number since Big Bang.
Dealing in gilt-edged stock is for cash settlement (payment the next day), and major institutional investors are likely to deal direct at net prices with a primary dealer rather than going through an agency broker. Small private investors will go through a broker as before (though commissions are lower than on equities) or can buy through the Bank of England Brokerage Service (see below).
By the mid 1990s there were fears that Britain’s gilt-edged market might be losing out in terms of competitiveness with some overseas government bond markets and change was once again in the air. One of the first steps to remedy this situation was the introduction of an open system of repurchase agreements (or repos) in the gilt market – they already existed in some of the more liquid overseas markets.
In a repo arrangement, the gilt-edged stock is sold with an agreement to buy it back later at a known price. Thus the seller is really arranging a short-term secured loan, with the gilts as security. In effect, repos allow much easier lending of gilt-edged stocks and borrowing against gilt-edged stocks. Somebody with a bearish view of the market, for example, is able to sell stock that he does not own and temporarily borrow the stock that he needs to deliver. Alternatively, investors wishing to buy gilts may be able to borrow sterling more cheaply by using the gilts as security. Repos should thus add to the liquidity of the market.
The authorities also decided to reduce the number of individual gilts in issue and concentrate on a smaller number of larger (and therefore more liquid) issues. And settlement via the CREST system should also contribute to liquidity. Greater transparency and predictability in gilt issuance has been achieved by advance publication of the issue schedule.
The other major change was the introduction in 1997 of a market in financially engineered government bonds known as strips. To grasp the principle, take a hypothetical example.
We will invent another government bond: call it Imaginary Treasury 6 per cent 2004. It pays interest twice yearly on 7 June and 7 December and is due to be repaid at its par value of 100 on 7 June 2004. Now suppose an investor bought this bond on 8 June 1999. The cash flows he can expect over the life of the bond are as shown in Table 13.5:
Income and capital payments on £1m face value of Imaginary
Treasury 6% 2004
|
|
Interest |
Capital |
|
|
£ |
£ |
1999 |
Dec-07 |
30,000 |
|
2000 |
Jun-07 |
30,000 |
|
2000 |
Dec-07 |
30,000 |
|
2001 |
Jun-07 |
30,000 |
|
2001 |
Dec-07 |
30,000 |
|
2002 |
Jun-07 |
30,000 |
|
2002 |
Dec-07 |
30,000 |
|
2003 |
Jun-07 |
30,000 |
|
2003 |
Dec-07 |
30,000 |
|
2004 |
Jun-07 |
30,000 |
1,000,000 |
Table 13.5
If our investor intends to hold the stock to redemption, it is clear that he can expect ten half-yearly interest payments of £30,000 and in June 2004 he can expect to receive £1,000,000 when the stock is redeemed. If the bond is ‘stripped’, what happens is that each of these receipts is treated as an investment in its own right. In other words, the right to receive a £30,000 interest payment in, say, June 2003 becomes a marketable investment. So do the rights to all the other interest payments. So does the right to receive the £1,000,000 capital repayment at the end of the day. So our bond with five years of life to run can be broken down into 11 different investments or strips.
But what are these rights or strips worth? They do not, after all, pay any income. They simply give the right to receive a certain sum at a certain date in the future. What this right is worth depends on the return you expect from your investment.
Remember the principle set out in Chapter 1. A sum of money that you will receive in the future is worth less than the same sum of money if you had it today. This is because, if you had it today, you could set it to work earning interest for you and it would therefore become worth more in the future. So we will assume that, in the market conditions of the time, you would expect a return of 4.8 per cent on your investment.
What, therefore, is £30,000 receivable in June 2003 – in four years’ time if we are starting from June 1999 – worth in June 1999? It is worth whatever sum will grow to £30,000 in four years’ time at a 4.8 per cent semi-annual interest rate (i.e. assuming interest paid in two equal annual instalments). The answer, as it happens, is £24,815. Another way of saying this is that £24,815 is the present value of £30,000 receivable in four years’ time at a 4.8 per cent semi-annual discount rate. Work it out. At 4.8 per cent semi-annual compound interest, £24,815 grows to £30,000 in four years. The table below shows the present value of all 11 components into which our £1,000,000 of gilt-edged stock can be stripped, on the assumption of a June 1999 starting date and a semi-annual discount rate of 4.8 per cent. In practice, the market prices of strips are expressed in relation to a redemption value of 100. So if £30,000 receivable in four years has a current value of £24,815, the price of this strip would be expressed as 82.72, since £24,815 is 82.72 per cent of £30,000.
Discounted value of payments on £1m face value of Imaginary
Treasury 6% 2004
Table 13.6
The calculations are inevitably a little technical, but they are necessary in order to explain the principle. If you want to do them yourself, incidentally (which you easily can do with a sophisticated calculator or a computer spreadsheet) look at the following formulae – skip the next few paragraphs if arithmetic turns you off, and continue at ‘Attractions of strips’.
To calculate what sum £1 today will grow to in the future at an annual rate of interest, the formula would be:
£1* (1 + interest rate) ^ number of years
We are using the computer symbols where an asterisk is a multiply sign, a slash is a divide sign and the pointed hat symbol means ‘raised to the power of’. And the interest rate is expressed as a decimal: thus 4.8 per cent would be 0.048.
Since interest on gilts is normally paid semi-annually, we have to adjust the formula to allow for this. The formula used in the table is therefore:
£1 * (1 + (interest rate / 2)) ^ (number of years * 2)
So, if we want to know the value of £1 in four years time at 4.8 per cent compound semi-annual interest, the sum is:
£l* (1 + (.048/2)) ^ (4 * 2)or:
£1* 1.024 ^ 8 = £1.2089
If £1 will grow to £1.2089 in four years, then £24,815 will grow to £24,815 multiplied by 1.2089, which is £30,000 as near as dammit. If you want to do the sum in reverse and find the present value of £1 receivable at a future date at a given annual interest rate, the calculation is:
£1*1 / (1 + interest rate) ^ number of years
However, again we have to allow for the fact that interest on gilts is normally paid semi-annually, so the formula used in Table 13.6 is:
£1 * 1 / (1 + (interest rate / 2)) ^ (number of years * 2)
If we want the present value of £1 receivable in four years at a 4.8% semi-annual interest rate, the sum is therefore:
£ 1 * 1 / (1 + (0.048 / 2)) ^ (4 * 2) or
£ 1 * 1 / 1.024 ^ 8 = 0.82718
If £1 receivable in four years is worth only 0.82718 today at a 4.8 per cent semi-annual discount rate, then £30,000 receivable in four years is worth £30,000 multiplied by 0.82718, which works out at £24,815.
So nowadays larger investors have a choice. They can buy government bonds which pay them interest twice a year. Or they can buy strips which pay no interest but provide a return all the same because the sum you get at the end of the day is above the price you paid initially and this difference can be expressed as the equivalent of an annual rate of compound interest. Strips are therefore much the same as zero coupon bonds: bonds that were never intended to pay interest but provide their return from the difference between the issue price and the higher price at which they will be redeemed.
What is the attraction of strips as an investment? They enable you to tailor an investment to your own exact requirements and they give you absolute certainty as to the sum you will receive on a particular date. An insurance company knows, say, that it will have to pay out precisely £30,000 in four years’ time under a savings plan it has sold. By buying the four-year interest payment strip, it knows it will receive exactly £30,000 at the relevant time so it will have the money to meet its commitment.
What is the difference between this and buying an interest-paying investment today (like a conventional unstripped gilt-edged stock) that will build up to £30,000 in four years? The problem is that you are never quite sure what return you will get on your money with an interest-paying bond. You may assume that, if you buy an interest-paying bond at a price that shows you a redemption yield of 4.8 per cent, then the return on your money will be exactly 4.8 per cent if you hold it until it is redeemed.
Unfortunately, this is not necessarily the case. The calculation of the redemption yield or internal rate of return (IRR) on a fixed-interest bond has to assume that the periodic interest payments that you receive can be reinvested at the same rate of interest as the redemption yield that you started with. In practice, this probably won’t happen. Buying strips instead of interest-bearing bonds eliminates this uncertainty.
Since the return on strips comes entirely in the form of capital gain, is it tax-free to a private investor? Unfortunately no. Tax has to be paid annually on the notional return, as if the strips were sold at the end of each tax year.
In Britain, the public has an opportunity to buy or sell the more liquid gilt-edged stocks without going through a broker at all, by using the Bank of England Brokerage Service. Commission charges on smaller transactions may be lower than a broker would charge. You may obtain a purchase form and a list of stocks available from a Post Office, by writing to the Bank of England’s Registrar’s Department or from the Bank’s website at www.bankofengland.co.uk/. You send your order by post with a cheque and the Bank tries to carry out on the same day all orders that it receives by first post. However, it cannot undertake to buy or sell stock at a particular price or a particular time.
Companies as well as governments often want to borrow money for long periods at fixed rates of interest. And, just like governments, they can do so by issuing fixed-interest bonds which become securities of the company.
When a company issues a bond, a few additional considerations apply that do not crop up with government bonds. First, a company (even the best company) is not as secure as the government. Investors assume that the government will always be able to pay the interest on its debt and repay the debt at the end of the day. The government can ultimately tap taxpayers for the money it needs. A company, on the other hand, has to be able to earn the profit from which it will pay the interest and must find the cash to repay the debt eventually. Companies, even large and reputable companies, do sometimes get into trouble and even go bust. A bond issued by a company will therefore need to offer a higher return than one issued by the government to compensate investors for the higher risk. A very large and safe company may not need to pay a great deal more than the government would. A smaller and less secure company might have to pay considerably more.
Second, investors are prepared to lend to the government for 25 years or so, because they assume that one government or another will still be around in 25 years. They may be more reluctant to lend to companies for such a long period. Very well-established companies or those with assets such as property which investors expect to increase in value may be able to borrow for very long periods. Others may have to settle for somewhat shorter terms.
Third, when the government issues a bond it might issue several billion pounds’ worth. Since there will be many thousands of investors in any single government bond, the bond will be easy to buy and sell in the secondary market without moving the price too much. In other words, it will be very liquid. Companies will normally issue bonds for rather smaller amounts and the bonds will not be quite so liquid. Again, investors expect some compensation for this factor in the form of additional return.
But the rates of return on company bonds will take the returns on ‘risk-free’ government bonds as their starting point. If, at a particular time, investors expect a redemption yield of, say, 4.8 per cent on a government bond repayable in ten years’ time, what rate of return would the company have to offer? The company’s financial advisers, who know the market well, might decide that the company would need to offer 100 basis points (one percentage point) more than the government to attract investors. If the government benchmark gilt – the one selected as a yardstick for medium-dated bonds – offers a redemption yield of 4.8 per cent, the company bond would therefore need to offer 5.8 per cent.
Example 13.2 Yields on ‘yardstick’ government bonds. Source: Financial
But bond prices can move up and down quite rapidly and it may still be a few days before the company bond is ready for issue. So the company or its advisers might say that the redemption yield on the new bond will be set at 100 basis points over the redemption yield on the benchmark gilt at 3 pm next Wednesday, the day of issue. If on that day the benchmark gilt is yielding 4.85 per cent to redemption, the new company bond will need to offer a redemption yield of 5.85 per cent.
This does not mean that the coupon will necessarily need to be 5.85 per cent. Instead, the company could issue the bond with a coupon of 5.8 per cent but issue it below its nominal value at a price (roughly 99.60 in this instance) which would provide investors with a redemption yield of 5.85 per cent over ten years. If the company making the bond issue were a smaller or lesser-known concern it would have to offer a higher yield – a greater spread over the benchmark gilt: say, 180 basis points. Its cost would thus be 7.65 per cent. The Financial Times publishes a table of yields on benchmark government bonds in different countries.
Once issued, company bonds respond to changes in interest rate expectations in much the same way as government bonds. But there is another factor that can affect their market price. Suppose something happens subsequently to affect investors’ confidence in the company that issued the bond. A year after the bond issue the company begins making losses and investors start to question whether it will be able to pay the interest. The general level of yields in the market has not changed, let us suppose, and the benchmark gilt is still yielding 4.85 per cent. But buyers of the company bond in the market, which carries a 5.8 per cent coupon, would now demand a considerably higher return than 5.85 per cent to compensate them for the higher risk that they now perceive.
This means that the price of the bond must fall. Suppose it falls to a price of 70 before investors are prepared to buy it. At this level, with 9 years of life still to run, it offers a redemption yield of 11.28 per cent (provided it does, in the event, pay the interest): no longer 100 basis points over the benchmark gilt yield but 643 basis points above it. If the company returns to profit, buyers of the bond will see a handsome profit themselves. If the company goes bust they might lose the whole of their investment. Buyers of company bonds are not just at the mercy of changes in interest rates. They can be affected by changes in the credit status of the company and changes considerably less dramatic than that in our example are taking place much of the time.
For this reason, company bonds may carry a credit rating issued by one of the independent rating agencies (see Chapter 17). This rating aims to reflect the degree of risk and will be amended if the company’s fortunes change.
Fixed-interest bonds issued by companies fall into two main categories: those that are secured and those that are unsecured. With a secured bond, the loan is normally secured on a specific asset or specific assets owned by the issuing company. If the company defaults on the terms of the bond, the asset or assets can be sold to provide the money to repay investors (though the position is slightly complicated by the 1986 Insolvency Act). This gives greater security than if the investors in the bond have to compete with other creditors for repayment if the company should get into trouble. It is similar to the system applying in the residential property market, where a lender to the homebuyer takes a mortgage on the property, which allows the home to be sold to repay the loan if necessary.
With an unsecured bond, the investor is relying mainly on the standing of the issuing company and its ability to earn the profits and generate the cash to pay the interest on the bond and repay it at the end of the day. Investors may insist on certain conditions or restrictive covenants to strengthen their hand. There might be upper limits on the amount of money the company could borrow and the company might have to stay within certain ratios between profits and interest charges.
All else being equal, a secured bond will normally be slightly cheaper for the issuing company than an unsecured one. In other words, the yield it has to offer to attract investors will be slightly lower. Traditionally, bonds issued in the domestic stockmarket were frequently secured whereas those issued in the euromarket or international market (see below) tend to follow American practice and are usually unsecured. But the division is not rigid.
There is another type of ‘fixed interest’ bond that you will come across sometimes, and that is the zero coupon bond which we mentioned briefly earlier. Its distinction is that it pays no interest at all during its life. The investor’s return comes entirely in the form of a gain to redemption. A company issues a bond at, say, a price of 55 and agrees to repay it at 100 in ten years’ time. In practice, this is much the same thing as a compound annual rate of interest of 6.2 per cent, but the investor has to wait for ten years to get this ‘interest’ as a lump sum.
Not all bonds offer a fixed return at all. Companies, like the government, have the option of issuing floating rate bonds instead and some types of company – particularly banks and other financial groups – use them a great deal more. The bonds, which are usually known as floating rate notes or FRNs pay a rate of interest that is geared to a widely accepted yardstick for interest rates such as LIBOR (see Chapter 15). The issuer agrees that the FRN will pay, say, 50 basis points (half of one percentage point) above the rate of LIBOR. In practice this means that the average rate of LIBOR will be taken over, perhaps, a six-month period. If average LIBOR was 6 per cent the FRN would pay 6 per cent plus the 50 basis points spread or 6.5 per cent in total in respect of that six months’ period.
We saw that with a bond that has a fixed coupon, the price in the market has to change to accommodate changes in interest rates in the economy. With an FRN the interest rate itself can change so that the market price does not need to adjust in the same way. The price is likely to stay far closer to its nominal value of 100 and in this sense the risk for the investor is considerably less, as are the possible gains. But if something happened to damage the credit standing of the issuing company, the price in the market could, of course, drop for this reason.
New types of bond and FRN are constantly being developed and tailored to investors’ requirements at a given time (see Chapter 17). And convertible bonds – bonds that may convert into shares – are a long-established part of the financing armoury (see Chapter 5). Nor do bonds necessarily need to be traded on a stockmarket at all. Companies may make private placements of bonds that are placed with (sold direct to) big investing institutions who will often hold them until they are redeemed.
At times of high inflation when long-term interest rates are high, UK companies have generally been reluctant to raise capital by issuing long-term fixed-interest bonds. They do not want to commit themselves to paying very high interest rates for 20 years or so when there is a chance that capital might become considerably cheaper at a later date. And many investors are very reluctant to buy fixed-interest bonds when they think that inflation will seriously erode the real value of their capital.
Issues of fixed-interest bonds by companies virtually dried up in the high-inflation era of the 1970s and they have been unpopular at times of high interest rates subsequently. But the lower rates of inflation of the recent past have seen a resurgence of interest in the corporate bond market. For investors, industrial debentures or corporate bonds have the advantage of offering rather higher returns than the government’s own bonds, still with quite a high level of safety.
UK companies are not limited to the domestic stockmarket when they wish to issue bonds. In the euromarket or international market the larger companies can issue bonds in sterling or in a range of other currencies. And they can also issue foreign-currency bonds in the domestic stockmarkets of a number of other countries, particularly the United States. The euromarkets need a chapter of their own (see Chapter 17). But it is important to note that many of the differences in issue and trading techniques for sterling bonds between Britain’s domestic stockmarket and the euromarket have now broken down. Dealers tend to talk of the two markets almost interchangeably.
The government’s Debt Management Office at www.dmo.gov.uk/ is now the main official source for information on the gilt-edged market and the stocks in issue. Included in the publications listed on the site is a useful guide for private investors called Gilts: An Investors Guide, which may be downloaded free. Information on gilt-edged market turnover is available on the London Stock exchange site at www.londonstockexchange.com/. However, the Bank of England site at www.bankofengland.co.uk/ still carries a certain amount of historical information on gilts, including the introduction of gilt strips, and provides forms for those wishing to buy or sell gilts via the Bank’s brokerage service. Investment websites in the UK are generally equity-oriented and information on gilts or bonds in general is more limited. But the Financial Times site at www.ft.com/ includes a ‘capital markets’ section that covers representative bond prices and yields. Information on the changes to the gilt settlement system may be found at the CREST site at www.crestco.co.uk/. Some background information on investment in gilts is available at the site of Kauders Portfolio Management at www.gilt.co.uk/. You may look at the bond yield curve for different countries in the ‘international bonds’ section of the international Bloomberg site at www.bloomberg.com/markets/. The Peter Temple Linksite at www.cix.co.uk/~ptemple/ also provides a link to a number of information sources on bonds.
