Gilts for innocents

Perfectly safe, but for some, perfectly baffling. John Andrew explains how to trust the Government and buy its debt

Legend has it that there was once a financial adviser who displayed a sign outside his premises stating that he advised on "pensions, unit trusts, life cover and guilts".

Gilts, as opposed to guilts, are actually marketable securities issued by Her Majesty's Government when it needs to borrow money. Contrary to popular opinion, the certificates that represent the securities are not - and never have been - edged with gold.

The stock market has given them this name because of their reputation as one of the safest forms of investments. Over hundreds of years, the British government has never failed to meet the interest and capital payments as they fall due.

However, this does not mean that gilts are without risk. A feature of all gilts issued today is that the stock will be redeemed at a specified future date. Then investors will receive the sum shown on their certificates which is known as the "par" or its "nominal" value.

However, before this time, the price of gilts traded on the stock market fluctuates. In addition, there are half-a-dozen gilts that are unlikely ever to be redeemed. These were issued many years ago and are known as "undated" stocks.

The price of gilts traded on the market moves up and down to reflect actual and anticipated changes in interest rates. If interest rates rise, the price of gilts falls. For example, suppose a gilt is issued that pays 5 per cent - that is its "coupon", which is the interest rate paid on the nominal amount of stock. Our 5 per cent gilt will pay pounds 5 a year per pounds 100 of its nominal value until it is redeemed.

If interest rates rise to 10 per cent, the price of our 5 per cent gilt will fall to pounds 50; if interest rates halve to 2.5 per cent per cent, the price of the stock will double to pounds 200. As the interest rate paid by conventional gilts is fixed, their value rises and falls so that the income paid reflects the general level of interest rates:

pounds 200 @ 2.5 per cent = pounds 5

pounds 100 @ 5 per cent = pounds 5

pounds 50 @ 10 per cent = pounds 5

Of course, in the real world, matters are more complex as gilts are redeemed at varying dates. This is another factor which influences the price of gilts traded on the stock market.

If you look at the price of gilts in The Independent - they are shown under government securities on the market report/shares page - you will see that conventional gilts are grouped according to their redemption date. Shorts are those that will be redeemed within five years, mediums between five and 12 years and longs after 12 years. Finally, there are undated gilts.

The most common names given to gilts are Exchequer and Treasury. However, their names are academic. What is important is their coupon and redemption date. When there are two dates, the Government may redeem the stock at any time between the two dates. The timing of the redemption will depend on the level of interest rates in the market at the time.

Prices for gilts are always quoted for pounds 100 nominal value of stock, with the pence being represented by fractions of a pound. You will notice that the price of most gilts is over pounds 100. If an investor buys a gilt above pounds 100 and holds the stock until redemption, a capital loss will result. However, this is compensated for in the dividend payments received.

As well as the current price, The Independent also shows the redemption yield. That is the total return to the investor if the stock is held to redemption. It is the sum of all the gross interest dividends and the capital gain or loss at redemption, expressed as an annual percentage. It is important to realise that this is not the interest yield, which is the gross interest rate that a holder of the stock will receive at the quoted market price.

The interest yield for any gilt which is trading above pounds 100 is always greater than its yield to redemption and is greater than the interest rates prevailing in the market generally.

There is no simple way of calculating the redemption yield. Indeed, those published in The Independent are derived using a computer program. Traditionally, when a gilt is trading above its nominal value, the redemption yield is based on its earliest redemption date. When it trades below pounds 100, it is calculated on the assumption that it will run its full course.

It is important to remember that although undated gilts also offer a guaranteed income and all trade below pounds 100, it is unlikely that they will ever be redeemed at their nominal value. The price at which they trade depends on the market's view of future interest rate trends.

Gilts are a complex subject, but they are nevertheless an attractive way of meeting certain investment needs. The Bank of England's advice to investors is simple - "consult a professional adviser", if in any doubt as to whether gilts are for them