Gilts are bonds issued by the UK government. The term ‘gilt’ comes
from gilt-edged securities, the official term for UK government bonds.
Gilts are the main method by which the UK government finances the short-
fall between its expenditure and its tax revenues, and as they are direct obli-
gations of the government they are the highest-rated securities in the
sterling markets. Their AAA-rating reflects in part the fact that the UK
government has never defaulted on an interest payment or principal repay-
ment in the history of the gilt market, as well as the strength and standing
of the UK economy. The market is also at the centre of the sterling finan-
cial asset markets and forms the basis for pricing of all other sterling assets
and financial instruments. As well as being safe investments, gilts are also
useful investments. They outperformed equities in 1998 and again in 2001.
That’s a bit like the chap entered for the steeplechase at your school sports
day also winning the 100 metres sprint: a bit of a bonus, because gilts hold
none of the risk of equities.
At the end of September 2002 there were 60 individual gilt issues in existence, representing nearly £242 billion nominal of debt outstanding. The majority of these are conventional fixed interest bonds, but there are also index-linked, double-dated and irredeemable gilts. Gilts are identified by their coupon rate and year of maturity; they are also given names such as Treasury or Exchequer. There is no significance attached to any particular name, all gilts are equivalent irrespective of their name.
Some gilts exist only in small quantities and are known as rump gilts. A full list of all gilts as at September 2005 is given in Appendix 3.1. The UK government issues gilts to finance its income deficit, previously known as the Public Sector Borrowing Requirement but now known as the Public Sector Debt Requirement. The actual financing requirement each fiscal year is known as the Central Government Net Cash Requirement (CGNCR). The CGNCR, being the difference between central exchequer income and expenditure, always reflects a borrowing requirement except on rare occasions when the central government runs a surplus, as in 1988 and in 1998. New issues of debt are also made to cover repayment of maturing gilts.
The responsibility for issuing gilts rests with the Debt Management
Office (DMO), an executive agency of Her Majesty’s Treasury. The
DMO is in charge of sterling debt management for the government. This
transfer of duties traditionally performed by the Bank of England (BoE)
was introduced after the Chancellor of the Exchequer handed over
control of UK monetary policy to a committee of the bank, the Mone-
tary Policy Committee, in May 1997. The DMO was set up in 1998 and
assumed its responsibilities on 1 April 1998. Over the few years prior
to this the gilt market had been subject to a series of reforms in its struc-
ture and operation, overseen by the BoE, designed to make gilts more
competitive as investment instruments and to bring the market up to
date. Recent innovations have included the introduction of an open
market in gilt repo and a new market in zero-coupon bonds known
as gilt strips, as well as improvements to the auction process. This
included introduction of an auction calendar and a policy of building up
large-volume, liquid benchmark issues.
Is this of relevance to private investors? Insofar as it reassures them that
the market will continue to function as a liquid and efficient one, yes, but
otherwise no - we need only be comfortable about the concept of investing
in gilts.
INTRODUCTION AND HISTORY
UK national debt dates from 1694 when the government of King William raised £1.2 million in order to finance a war against France. The Bank of England was founded the following year. The currency itself however dates from much earlier than this, for instance the word pondus was a Latin word meaning ‘weight’ but signified the weight of the coin of money; while the ‘£’ sign originates from the designation for ‘libra’, used to denote the pound. The term sterling originates from ‘esterling’, silver coins introduced during the reign of King Henry II in the twelfth century.2 From this begin-ning the UK national debt has grown steadily, experiencing rapid growth during the wars in 1914-18 and 1939-45. Steady growth in national debt was observed in all developed economies in the post-war period.
As the gilt market forms the cornerstone of the sterling asset markets, the gilt yield curve is the benchmark for banks and corporates when setting interest rates and borrowing funds. As is common in many countries, government bonds in the UK form the largest sector within the UK bond markets; in September 2002 the nominal value outstanding comprised just over 51 per cent of the total nominal value of UK bonds. This figure was also larger than the total volume of sterling Eurobonds in issue at that time, approximately £200 billion. The remainder was made up of domestic bonds such as debentures and bulldogs.
MARKET INSTRUMENTS
Conventional gilts
The gilt market is essentially plain vanilla in nature. The majority of gilt
issues are conventional fixed interest bonds. Conventional gilts have a fixed
coupon and maturity date. By volume they made up 76 per cent of the
market in September 2002. Coupon is paid on a semi-annual basis. The
coupon rate is set in line with market interest rates at the time of issue, so
the range of coupons in existence reflects the fluctuations in market inter-
est rates Unlike many government and corporate bond markets, gilts can be
traded in the smallest unit of currency, and frequently nominal amounts
change hands in amounts quoted down to one penny (£0.01) nominal size.
Individual gilts are given names such as the 7% Treasury 2002 or the 9%
Conversion 2011. There is no significance attached to the name given to a
gilt, and they all trade in the same way; most issues in existence are now
‘Treasury’ issues, although in the past it was sometimes possible to iden-
tify the purpose behind the loan by its name. For example a ‘Conversion’
issue usually indicates a bond converted from a previous gilt. The 3% Gas
1995/98 was issued to finance the nationalisation of the gas industry and
was redeemed in 1998.
Gilts are registered securities. All gilts pay coupon to the registered holder as at a specified record date; the record date is seven business days before the coupon payment date. The period between the record date and the coupon date is known as the ex-dividend or ‘ex-div’ (‘xd’) date; during the ex-dividend period the bond trades without accrued interest. This is illustrated in Figure 1.
Index-linked gilts
The other major gilt instruments are index-linked (I-L) gilts, or ‘linkers’.
The UK was one of the first countries to introduce index-linked govern-
ment bonds, with an issue in 1981. I-L gilts are designed to provide
investors with an inflation-protected, real return from their bondholding. In
September 2002 approximately 19 per cent of gilts in issue were linkers. I-
L gilts link both their coupon and redemption payments to the UK retail
price index (RPI), and this adjustment should in theory preserve the real
value of investors’ income and capital, independent of the rate of inflation.
The RPI figure for eight months prior to the relevant cash flow is used to
adjust the final value of each payment as it becomes due. To adjust a
coupon payment therefore, the nominal value (this is the coupon rate) is
adjusted using the RPI value recorded eight months prior to the bond’s
issue date and the RPI value recorded eight months prior to the coupon
payment date.
The use of an earlier RPI index level, known as an ‘indexation lag’, is
because the actual cash flow needs to be known six months before it is paid,
so enabling the accrued interest on the bond to be calculated during the
interest period. This accounts for six months of the lag, while RPI figures
themselves are always issued one month after the month to which they
relate (for instance, September’s RPI is issued in October). The final
redemption is treated in the same way. The existence of this indexation lag
means that in practice I-L gilt returns are not completely protected from
inflation.
The coupon level for I-L gilts is typically 2 per cent or 2½ per cent, which is lower than conventional gilts issued since the 1950s. This reflects the fact that, as the coupon is protected from inflation, the nominal coupon value is the real interest rate expected during the bond’s life. Historically the real return on gilt stock has been around 2-3 per cent. The importance of indexed gilts in the market as a whole reflects the attraction that such debt has for institutional investors. While it might be of value for private investors, in the current low inflationary environment it is perhaps less useful. Since the establishment of the Monetary Policy Committee (MPC) and granting of operational independence to the Bank of England in 1997, there are good reasons for thinking that inflation should not be a problem barring external shocks, and so index-linked gilts should continue to be of less interest to private investors than conventional gilts.
The yield spread between I-L and conventional gilts fluctuates over time and is influenced by a number of factors and not solely by the market’s view of future inflation (the implied forward inflation rate). The market uses this yield spread to gauge an idea of future inflation levels. The other term used to describe the yield spread is breakeven inflation, that is, the level of inflation required that would equate nominal yields on I-L gilts with yields on conventional gilts.
Example 3.1:
real yields versus conventional gross redemption yields
On 10 October 1999 the 2% I-L Treasury 2006 gilt is trading at £231.90, a real yield of 2.209 per cent (assuming an inflation rate of 3 per cent). A double-dated gilt, the 3½% Funding 1999-2004, is trading at £92.72 which is equivalent to a gross redemption yield of 5.211 per cent, assuming the stock is redeemed at the final maturity date. A private investor currently holding the I-L gilt is recommended by her stockbroker to switch into the double-dated issue. The investor is a higher-rate taxpayer, and there is no capital gains tax to pay on gilt investments. Do you agree with the stockbroker’s recommendation? What reasons lie behind your decision?
In order to compare the two gilts we need to make an assumption about future inflation. The yield spread between the two bonds implies a forward inflation rate of just over 3 per cent. Therefore if the actual inflation rate to 2004 averages more than 3 per cent, the investor would have been better served by the I-L gilt. At a price of £92.72 the conventional gilt offers a capital gain on maturity of £7.28.
The coupon on the investment is only 3.50 per cent, however.
Compare this with an expected coupon of 4.50 per cent for the I-L
bond, if we assume that inflation will stay at or around the MPC’s
target rate of 2.5 per cent. On maturity however the price of the I-L
gilt will be £196.00, which we calculate using the current RPI level
until maturity (this gives us 165.1 1.0257) and assuming 2.5 per
cent inflation to 2006. This will result in a capital loss for the investor.
As there is income tax to pay on gilts, the conventional gilt probably
then is the better option for the investor who will pay tax at the higher
rate on the coupon income.
However there are a range of factors for the investor to consider, and the most significant is the extent to which she wishes to protect herself against unexpected inflation. The final decision must also consider the investor’s portfolio as a whole; for example a high level of cash holdings would imply a greater exposure to inflation, which would swing the argument in favour of holding I-L gilts.
Comparing the yield levels on indexed bonds across markets enables analysts to assess the inflation expectations in several countries at once. While this is carried out frequently, it is important to factor in the non-inflation expectation considerations that make up bond yields. A high level of demand for I-L bonds, or an overvalued conventional bond market, can sometimes imply a lower forward inflation rate than is realistic.
Double-dated gilts
There are currently six double-dated gilts in existence, but they represent a small proportion of the market and have not been issued since the 1980s. Double-dated gilts have two maturity dates quoted, and under the terms of issue the government redeems them on any day between the first and second maturity dates, provided at least three months notice is given. As with callable bonds in the corporate market, the government will usually redeem a double-dated bond early if it is trading above par, since this indi-cates that the coupon on the bond is above the prevailing market interest rate. Where the price is below par the bond will be allowed to run to the final redemption date. An example of the latter is the 3½% Funding 1999-2004, which traded well below par and therefore was run to its final maturity date of 14 July 2004, although the government could have redeemed it at any point between 1999 and July 2004, providing it gave at least three months notice.
Double-dated issue are usually less liquid than conventional or I-L gilts,
mainly because there is a relatively small amount in issue and also because
a larger proportion are held by personal investors. They also tend to have
high coupons, reflecting the market rates in existence at the time they were
issued.
Floating rate gilts
In recent years the government has issued conventional floating rate gilts, the last of which matured in March 2001. Floating rate gilts pay coupon on a quarterly basis at the London Interbank Bid Rate (LIBID) minus 12.5 basis points. The BoE calculates the coupon level based on the LIBID fixing for the day before the coupon payment is due.3 The liquidity of floating rate gilts is comparable to conventional gilts.
Gilt strips
Gilt strips are zero-coupon bonds created from conventional coupon gilts. Only issues actually designated as strippable gilts may be stripped. They are considered separately later in this chapter.
Undated gilts
The most esoteric instruments in the gilt market are the undated gilts,
also known as irredeemable gilts or consols. These are very old issues;
indeed some date from the nineteenth century.4 There are eight such
issues, and they do not have a maturity date. Redemption is therefore is
at the discretion of the government. Some undated issues are very illiq-
uid. The largest issue is the 3½% War Loan, with just over £1.9 billion
in existence. In the past the BoE undertook conversions of the less liquid
irredeemable bonds into War Loan, so that for all but this stock and the
2½% Treasury bond there are only rump amounts remaining. The
government can choose to redeem an undated gilt provided a requisite
notice period is given (this varies for individual issues but generally is
three months), but in practice - given that the coupon on these bonds is
very low - is unlikely to do so unless market interest rates drop below
say 3 per cent. A peculiarity of three of the undated gilts is that they pay
interest on a quarterly basis.
Treasury bills
Strictly speaking Treasury bills (T-bills) are not part of the gilts market
but form part of the sterling money markets. They are short-term
government instruments, issued at a discount and redeemed at par. The
most common bills are three-month (or 91-day) maturity instruments,
although in theory any maturity between one-month and 12-month may
be selected. In the past the BoE has issued one-month and six-month
bills in addition to the normal three-month maturity bills. Bills are issued
via a weekly tender at which anyone may bid. Generally clearing banks,
building societies and discount houses take an active part in the bill
market.
In debt capital markets the yield on a domestic government T-bill is
usually considered to represent the risk-free interest rate, since it is a
short-term instrument guaranteed by the government. This makes the T-
bill rate, in theory at least, the most secure investment in the market. It is
common to see the three-month T-bill rate used in corporate finance
analysis and option pricing analysis, which often refer to a risk-free
money market rate.
The responsibility for bill issuance was transferred to the DMO from the BoE in 1999. The DMO set up a slightly changed framework6 in order to facilitate continued market liquidity. The main elements of the framework included a wider range of maturities and a larger minimum issue size at each weekly tender, plus a guaranteed minimum stock in issue of £5 billion. The DMO also pre-announces the maturities that will be available in the next quarter’s tenders. The settlement of T-bills has been fixed at the next working day following the date of the tender.
Maturity breakdown of stock outstanding
Gilts are classified by the DMO and the Financial Times as ‘shorts’ if
maturing in 0-7 years, ‘mediums’ if maturing in 7-15 years and ‘longs’ if
maturing in over 15 years’ time. Gilt-edged market makers (GEMMs)
usually apply a different distinction, with shorts being classified as 0-3
years, mediums as 4-10 years and longs as those bonds maturing in over
10 years.
Market trading conventions
Gilts are quoted on a clean price basis, for next day settlement. This is known as ‘cash’ settlement or T+1.
Price quote
From 1 November 1998 gilt prices changed from pricing in ticks to pricing in decimals. (A tick is 1/32nd of a point; it was therefore equal to 0.03125. The tick price quote is employed in the US Treasury market.) Prices are now displayed as £ and pence per cent of stock. Auction bids are to two decimal places and gilt-edged market maker (GEMM) reference prices are up to four decimal places. The bid-offer spread is very close in the gilt market, reflecting its liquidity and transparency. For bonds up to ten years in maturity it is possible to receive quotes as narrow as £0.01 between bid and offer, although of course private investors will be quoted a wider spread.
Daycount convention
The accrued interest daycount convention for the calculation of accrued interest was changed from ACT/365 to ACT/ACT, from 1 November 1998. In Chapter 2 we showed how this results in slightly different results for the same number of days of accrued interest; however private investors need not be unduly concerned with this.
Market prices
Private investors can check the previous day’s closing prices for gilts in the Financial Times. Gilt prices are not usually very volatile so these prices should be good enough for most dealing decisions. Prices can also be checked on the DMO’s website, which is www.dmo.gov.uk and can be used to check historical prices.
INVESTING IN GILTS
It is very easy to buy and sell gilts. As a private investor, you can check prices and transact gilts at a share shop, or through certain accountants and solicitors. A share shop is a high street bank that has been set up with a terminal that allows instant share dealing. You can of course buy and sell gilts through your stockbroker. In addition it is perfectly legal for an individual to sell a gilt to another private investor, as long as the transaction is properly recorded. Prices and yields can be tracked from the Financial Times or a website such as the DMO’s, which is very useful. The exact page address is
http://www.dmo.gov.uk/gilts/data/f3gem.htm
However as Leo Gough says in his book How The Stock Market Really
Works (2001), the best way to buy and sell gilts is via the Royal Mail: in
other words, by post. This service is provided by the Bank of England, and
used to be known as the National Savings Stock Register but now appears
to be called the Bank of England Brokerage Service. This is a straightfor-
ward process, and the Bank undertakes to transact orders on the day they
are received, although this not guaranteed. Full information is available
from the Bank’s website, www.bankofengland.co.uk, and the actual page
web link is
http://www.bankofengland.co.uk/Links/setframe.html
As well as the application forms, which can be downloaded as Adobe Acro-
bat files (.pdf), this site contains much useful information including a guide to investing in gilts, a list of dividend dates, commission rates, and sundry other details.7 The commission rates are very good value for money compared with other broker rates, but of course the execution is not real-time.
TAXATION
Gilts are free of capital gains tax. Coupon interest is payable gross, without deduction of withholding tax. Investors who are resident in the UK for tax purposes are liable to pay income tax at their marginal rate on gilt coupons, however. Therefore interest received, including the inflation uplift on I-L gilts, must be declared on annual tax returns.
The tax treatment for resident private investors is summarised below.
Resident private investors
Individual private investors resident in the UK are liable for income tax on gilt coupon interest received. This includes accrued interest earned during a short-term holding. Capital gain made on a disposal of gilts is not liable to tax. Gains accruing on gilt strips are taxable, however, on an annual basis. Strip earnings are taxed as income on an annual basis, irrespective of whether the strip has actually been sold. That is, the tax authorities deem a strip to have been sold and repurchased at the end of the tax year, with any gain taxed as income. A savings vehicle introduced in April 1999, known as an Individual Savings Account (ISA), allows individuals to hold gilts free of both income and capital taxes. There is a limit on the amount that may be held, which is a maximum of £5,000 per annum from tax year 2000/01 onwards. Gilt strips may also be held free of tax in an ISA, within the £5,000 yearly limit.8
Overseas investors
Investors who are resident overseas, both corporate and individual, are exempt from UK tax on gilt holdings. Prior to April 1998 only gilts designated as ‘Free of Tax to Residents Abroad’ (FOTRA) paid gross coupons automatically to overseas residents; however from that date all gilts have been designated FOTRA stocks and thus overseas investors receive gross gilt coupons.
Unlike UK equity market transactions, there is no stamp duty or stamp duty reserve tax payable on purchases or sales of gilts.
MARKET STRUCTURE
The gilt market operates within the overall investment business environ-
ment in the UK. As such wholesale market participants are regulated by the
Financial Services Authority (FSA), the central regulatory authority
brought into being by the newly elected Labour government in 1997. The
FSA regulates the conduct of firms undertaking business in the gilt market;
it also supervises the exchanges on which trading in gilts and gilt deriva-
tives takes place. The previous regulatory regime in the UK markets, as
conducted under the Financial Services Act 1986, consisted of market
participants being authorised by self-regulatory organisations such as the
Securities and Futures Authority (SFA). The FSA was set up initially
through merging all the different self-regulatory bodies. Hence gilt market
makers (known as gilt-edged market makers or GEMMs) and brokers are
authorised by the FSA. The FSA became the overall market regulator for
all practitioners at the end of 2000.9
The gilt market is an ‘over-the-counter’ market, meaning that transactions are conducted over the telephone between market participants. However all individual issues are listed on the London Stock Exchange (LSE), which as a Recognised Investment Exchange is also supervised by the FSA.
MARKET MAKERS
Just as in the USA and France for example, there is a registered primary dealer system in operation in the UK government bond market. The present structure dates from ‘Big Bang’in 1986, the large-scale reform of the London
market that resulted in the abolition of the old distinction between jobbers
and brokers and allowed firms to deal in both capacities if they so wished. It
also resulted in stock and share trading moving off the floor of the Stock
Exchange and into the dealing rooms of banks and securities houses. Firms
that wished to provide a two-way dealing service and act on their own
account registered as gilt-edged market makers. In 1986 there were 29
companies so registered, most of which were the gilts trading arms of the
large banks. Firms registered as GEMMs with the Bank of England, and until
1998 there was a requirement for GEMMs to be separately capitalised if they
were part of a larger integrated banking group. This requirement has since
been removed. In September 2002 there were 16 firms registered as GEMMs,
which must now be recognised as such by the DMO. GEMMs are also
required to be members of the LSE.
The key obligation of GEMMs is to make two-way prices on demand in all gilts, thereby providing liquidity to the market. From his time working as a GEMM the author knows that some firms observe this requirement more closely than others! Certain gilts that the DMO has designated as rump stocks do not form part of this requirement.
In return for carrying out its market-making obligations, a GEMM receives certain privileges exclusive to it, which are:
the right to make competitive telephone bids at gilt auctions and tap issues a reserved amount of stock at each auction, available at non-competitive bid prices (currently this is 0.5 per cent of the issue for each GEMM, or 10 per cent if an I-L gilt) access to the DMO’s gilt dealing screens, through which the GEMM may trade or switch stocks a trading relationship with the DMO whenever it wishes to buy or sell gilts for market management purposes the facility to strip gilts
a quarterly consultation meeting with the DMO, which allows the GEMM to provide input on which type of stocks to auction in the next quarter, plus advice on other market issues access to gilt inter-dealer broker (IDB) screens.
In 1998 the DMO set up a separate category of GEMMs known as index-
linked GEMMs (IG GEMMs). A firm could opt for registration for either or both of the categories. The role of an IG GEMM is the same as for conven-
tional GEMMs, applied to index-linked gilts. An IG GEMM has the same obli-
gations as a GEMM with respect to I-L gilts, and an additional requirement
that it must seek to maintain a minimum 3 per cent market share of the I-L gilt market. Therefore an IG GEMM must participate actively in auctions for I-L stock. In addition to the privileges listed above, IG GEMMs also have the right to ask the DMO to bid for any I-L gilt. In September 2002 eight of the 16 GEMMs were also registered as IG GEMMs.
Private investors do not deal with GEMMs.
The role of the Bank of England
Although the responsibility for UK government debt management has been transferred to the DMO, the BoE continues to maintain a link with the gilt market. The Bank is also involved in monitoring other sterling markets such as gilt futures and options, swaps, strips, gilt repo and domestic bonds. The Bank’s Quarterly Bulletin for February 1999 listed its operational role in the gilt market as:
Calculating and publishing the coupons for index-linked gilts, after the publication of each month’s inflation data and inflation index.
Setting and announcing the dividend for floating-rate gilts, which is calculated as a spread under three-month LIBID each quarter.
Operating the BoE brokerage service, a means by which private investors can buy and sell gilts by post instead of via a stockbroker. This service was previously operated by National Savings, the governments savings bank for private retail customers. Private investors sometimes wish to deal in gilts by post as usually commission charges are lower and it is a user-friendly service.
This is in addition to the normal daily money market operations, which keep the Bank closely connected to the gilt repo market. The BoE’s dealers also carry out orders on behalf of its customers, primarily other central banks.
The BoE has a duty to ‘protect the interests of index-linked gilt investors’ (DMO 1999). This is a responsibility to determine whether any future changes in the composition of the RPI index would be materially harmful to I-L gilt holders, and to effect a redemption of any issue, via HM Treasury, if it feels any change had been harmful.
ISSUING GILTS
Auctions are the primary means of issuance of all gilts, both conventional and index-linked. They are generally for £2-3 billion nominal of stock on a competitive bid price basis. Auctions of index-linked gilts are for between £0.5 billion and £1.25 billion nominal. The programme of auctions is occa-
sionally supplemented in between auctions by sales of stock ‘on tap’. This is an issue of a further tranche of stock of a current issue, usually in condi-
tions of temporary excess demand in that stock or that part of the yield curve. That said, only one conventional stock has been tapped since 1996, a £400 million tap in August 1999. The DMO has stated that tap issues of conventional gilts will only take place in exceptional circumstances.
After an auction the authorities generally refrain from issuing stocks of a similar type or maturity for a ‘reasonable’ period. Such stock will only be issued if there is a clear demand.
The 1996/97 remit for gilt issuance was accompanied by changes to the structure for gilt auctions. These changes were designed to encourage participation in auctions and to make the process smoother. The average size of auctions was reduced and a monthly schedule put in place; periodic dual auctions were also introduced. Dual auctions allow the issue of two stocks of different maturity in the same month, which moderates the supply of any one maturity and also appeals to a wider range of investors. GEMMs were allowed to put in bids by telephone up to five minutes before the close of bidding for the auction, which allowed them to accommodate more client demand into their bids. Instituting a pre-announced auction schedule at the start of the fiscal year further assists market transparency and predictability in gilt auctions, which reduced market uncertainty. In theory a reduction in uncertain should result in lower yields over the long term, which reduce government borrowing costs.
The DMO has a slightly different auction procedure for I-L gilts. Unlike conventional gilts, which are issued through a multiple price auction, I-L gilts are auctioned on a uniform price basis. This reflects the higher risks associated with bidding for I-L stock. In an auction for a conventional gilt, a market maker will be able to use the yields of similar maturity stock currently trading in the market to assist in her bid; in addition a long position in the stock can be hedged using exchange-traded gilt futures contracts.
There is a very liquid secondary market in conventional gilts. For these reasons a market maker will be less concerned about placing a bid in an auction without knowing at what level other GEMMs are bidding for the stock. In an I-L gilt auction there is a less liquid secondary market and it is less straightforward to hedge an I-L gilt position. There are also fewer I-L issues in existence; indeed there may not be another stock anywhere near the maturity spectrum of the gilt being auctioned. The use of a uniform price auction reduces the uncertainty for market makers and encourages them to participate in the auction.
Auction procedure
As part of its government financing role, HM Treasury issues an auction calendar just before the start of the new financial year in April. The DMO provides further details on each gilt auction at the start of each quarter in the financial year, when it also confirms the auction dates for the quarter and the maturity band that each auction will cover. For example, the quar-
terly announcement might state that the auction for the next month will see a gilt issued of between four and six years maturity. Announcements are made via Reuters, Telerate and Bridge news screens. Eight days before the auction date the DMO announces the nominal size and the coupon of the stock being auctioned. If it is a further issue of an existing stock, the coupon obviously is already known. After this announcement, the stock is listed on the LSE and market makers engage in ‘when issued’ trading (also known as the grey market). When issued trading involves buying and sell-ing stock to the forward settlement date, which is the business day after the auction date. As in the Eurobond market, when issued trading allows market makers to gauge demand for the stock amongst institutional investors, and also helps in setting the price on the auction day.
Conventional gilts
In conventional gilt auctions, bidding is open to all parties including
private individuals. Institutional investors will usually bid via a GEMM.
Only GEMMs can bid by telephone directly to the DMO.10 Other
bidders must complete an application form. Forms are made available
in the national press, usually the Financial Times. This makes it easy for
private investors to apply for new issue gilts. The application form
allows you to specify either a nominal amount of stock, in which case
you must send in an ‘open’ cheque with the form, or an actual amount
of cash to invest.
For the market professionals, bidding can be competitive or non-compet-
itive. In a competitive bid, participants bid for one amount at one price, for a minimum nominal value of £500,000. If a bid is successful the bidder will be allotted stock at the price it put in. There is no minimum price. Tele-
phone bidding must be placed by 10.30 am on the morning of the auction and in multiples of £1 million nominal. Bidding is closed at 10.30 am. In a non-competitive bid, GEMMs can bid for up to 0.5 per cent of the nominal value of the issue size, while others can bid for up to a maximum of £500,000 nominal, with a minimum bid of £1,000. Non-competitive bids are allotted in full at the weighted-average of the successful competitive bid price. In both cases, non-GEMMs must submit an application form either to the BoE’s registrar department or to the DMO, in both cases to arrive no later than 10.30 am on the morning of the auction.
The results of the auction are usually announced by the DMO by 11.15
am. The results include the highest, lowest and average accepted bid
prices, the gross redemption yields for these prices, and the value of non-
competitive bids for both GEMMs and non-GEMMs. The DMO also
publishes important information on auction performance, which is used
by the market to judge how well the auction has been received. This
includes the difference between the highest accepted yield and the aver-
age yield of all accepted bids, known as the tail, and the ratio of bids
received to the nominal value of the stock being auctioned, which is
known as the cover. A well-received auction will have a small tail and
will be covered many times, suggesting high demand for the stock. A
cover of less than 1.5 times is viewed unfavourably in the market, and the
price of the stock usually falls on receipt of this news. A cover over two
times is well received.
On rare occasions the cover will be less than one, which is bad news for the sterling bond market as a whole. A delay in the announcement of the auction result is sometimes taken to be as a result of poor demand for the stock. The DMO reserves the right not to allot the stock on offer, and it is expected that this right might be exercised if the auction was covered at a very low price, considerably discounted to par. The DMO also has the right to allot stock to bidders at its discretion. This right is retained to prevent market distortions from developing, for example if one bidder managed to buy a large proportion of the entire issue. Generally the DMO seeks to ensure that no one market maker receives more than 25 per cent of the issue being auctioned for its own book.
Index-linked gilts
Auction bids for I-L gilts are also competitive and non-competitive. Only IG GEMMs may make competitive bids, for a minimum of £1 million nominal and in multiples of £1 million. For I-L gilts there is a uniform price format, which means that all successful bidders receive stock at the same price. A bid above the successful price will be allotted in full. Non-competitive bids must be for a minimum of £100,000, and will be allotted in full at the successful bid price (also known as the ‘strike’ price). IG GEMMs are reserved up to 10 per cent of the issue in the non-competitive bid facility. Non-IG GEMMs must complete and submit an application form in the same way as for conventional gilt auctions.
The DMO reserves the right not to allot stock, and to allot stock to
bidders at its discretion. The maximum holding of one issue that an
IG GEMM can expect to receive for its own book is 40 per cent of the
issue size.
Conversions
In the new reformed environment of the gilt market, the emphasis is on having a large, liquid supply of benchmark issues in existence. The BoE used conversion offers to switch holdings of illiquid gilts into more liquid benchmark stocks. The DMO has instituted a formal conversion programme. Conversion offers are made to bondholders to enable them to exchange (convert) their gilts into another gilt. The new gilt is usually the benchmark for that maturity. The aim behind conversion offers is to build up the issue size of a benchmark gilt more quickly than would be achieved by auctions alone, which are a function of the government’s borrowing requirement. A period of low issuance as a result of healthy government finances would slow down the process of building up a liquid benchmark. By the same token, conversions also help to increase the size and propor-
tion of strippable gilts more quickly. Conversions also, in the words of the DMO, concentrate liquidity across the yield curve by reducing the number of illiquid issues and converting them into benchmark issues. Illiquid gilts are usually high coupon issues with relatively small issue sizes. In the past for example, double-dated gilts have been converted into benchmark gilts.
Gilts that may be converted are usually medium and long-dated bonds
with less than £5 billion nominal outstanding. The current distribution of a
gilt is also taken into consideration: issues that are held across a wide range
of investors, particularly private retail investors, are less likely to be offered
for conversion for the reason that the offer will probably not be taken up
widely.
HM Treasury and the DMO provide for liquid benchmark gilts at the 5, 10, 25 and 30-year maturity end of the yield curve. Conversion assists this process. The DMO uses the forward yield curve generated by its yield curve model in setting the terms of the conversion offer. The aim of the process is to make an offer to bondholders of the ‘source’ stock such that a large proportion of the stock is converted at a value fair to both the bondholder and the government.11
The conversion ratio is calculated using the dirty price of both source and ‘destination’ gilts. Both bond cash flows are discounted to the conver-
sion date using the forward yield curve derived on the date of the conver-
sion offer announcement. This approach also takes into account the ‘pull to
par’ of both stocks; the running cost of funding a position in the source stock up to the conversion date is not taken into account. Conversion terms are announced three weeks before the conversion date, although an inten-
tion to convert will have been announced one or two weeks prior to this.
On announcement of the conversion terms, the DMO holds the fixed terms, in the form of a fixed price ratio of the two stocks, open for the three-week offer period. If the terms move in bondholders’ favour they can convert, whereas if terms become unfavourable they may choose not to convert. It is not compulsory to take up a conversion offer. Holders of the source stock may choose to retain it and subsequently trade it, or hold it to maturity. However the source stock will become less liquid and less widely held after the conversion, more so if the offer is taken up in large quanti-ties. If the remaining amount of the source stock is so small that it is no longer possible to maintain a liquid market in it, thereby making it a rump stock, GEMMs are no longer required to make a two-way price in it. Even if the stock does not end up as a rump issue, the bid-offer spread for it may widen. However these are not considerations if the investor is seeking to hold the bond to maturity. The DMO will announce if a stock acquires rump status; it also undertakes to bid for such stocks at the request of a market maker, as assistance towards the maintenance of an orderly market.
GILT STRIPS
Strips are the simplest type of bond in the market, because they have just one cash flow - the principal payment on maturity. As such they are zerocoupon bonds, and are discounted securities, because they are issued at a discount to their face value and then redeemed at par. They are ideal investments for private investors, because there are no coupon payments to worry about reinvesting, and they can be purchased with maturity dates to suit particular requirements.
Market mechanics
A strip is a zero-coupon bond, that is, a bond that makes no coupon payments during its life and has only one cash flow, its redemption payment on maturity. ‘Stripping’ a bond is the process of separating a stan-
dard coupon bond into its individual coupon and principal payments, which are then held separately and traded in their own right as zero-coupon bonds. For example a ten-year gilt can be stripped into 21 zero-coupon bonds, comprised of one bond from the principal repayment and 20 from the semi-annual coupons. Coupon payments due in 6, 12, 18 and so on months from the stripping date would become 6, 12, 18 and so on month zero-coupon bonds. The stripping process is carried out by a market maker - you don’t have to worry about it.
You can buy strips via a stockbroker, but not through the post. This is because when strips were introduced the BoE believed that strips, which carried greater interest-rate risk than conventional gilts of similar maturity, should not be able to be purchased by retail investors unless they were aware of their characteristics, and the stockbroker plays the role of making them aware. This is unfortunate, because one of the handy things about gilts (well, conventional gilts) is that they can be bought and sold by post, directly with the government’s National Savings arm. It is not too difficult to understand strips, so we can hope they become available through the post as well.
Strips are fully fledged gilts; they remain registered securities and liabilities of HM government, therefore they have identical credit risk to conventional gilts. Only gilts designated as strippable may be stripped: in fact all benchmark gilts are strippable. Since benchmark gilts are issued with coupon dates either on 7 June and 7 December or 7 March and 7 September, it means that strips are available with maturity dates every quarter, every year until 2055, the maturity year of the longest-dated gilt. This allows investors to match their investment timeframes easily with strips.
Stripped coupons from different gilts but with the same coupon dates are fully fungible; this increases their liquidity. At the moment there is no fungibility between coupon and principal strips, although this remains under review and may be possible at a later date.
A complete table of strip prices and yields can be viewed on the DMO’s website.
Pricing convention
The BoE consulted with GEMMs before the introduction of the strips market on the preferred method for pricing strips. The result of this consultation was announced in May 1997, when the Bank stated that strips would trade on a yield basis rather than a price basis. The day count convention adopted, in both the conventional and strips market, was ACT/ACT.
It is handy for investors that strips are quoted in yield terms: they know exactly what yield they are getting. And unlike coupon bonds, the yield quoted for a strip is the true yield that will be received by the investor. Bear in mind that the yield is converted to a price when working out the total consideration (there is no accrued interest to worry about either). Remember that a fall in yields is good if you hold strips: it means that the price is going up. Of course, the price of the strip will gravitate slowly but surely to par, and will be par on its maturity date.
Interest rate risk for strips
Strips have a longer duration than equivalent maturity conventional bonds. As they are zero-coupon bonds their duration is equal in time to their maturity. The duration of a strip will decline roughly in parallel with time, whereas for a conventional bond the decline will be less. For a given modified duration, a strip will be less convex than a coupon bond. The following points highlight some of the salient points about how duration and convexity of strips compare with those of coupon bonds:
Strips have a Macaulay duration equal to their time in years to maturity. Strips have a higher duration than coupon bonds of the same maturity. Strips are more convex than coupon bonds of the same maturity.
Strips are less convex than coupon bonds of the same duration.
The reason that a strip is less convex than a conventional coupon bond of the same duration is that the coupon bond will have more dispersed cash flows than the strip. Although strips are less convex than bonds of identical duration, a high duration conventional gilt (6% Treasury 2028) had a duration of 15.56 years (modified duration 15.26) in March 1999, whereas the principal strip from that bond had a duration of 29.77 years at that time (modified duration 29.14). Long strips are therefore the most convex instruments in the gilt market.
Usefulness for private investors
Strips have a large number of uses for investors and traders. The following properties of strips make them potential attractive investments for investors:
simplicity of one cash flow at maturity allows matching to future liabilities
no reinvestment risk, as associated with conventional coupon-bearing
bonds tax advantages if held within an ISA for UK investors.
Gilts are free of capital gains tax. However the Inland Revenue will treat strip price increases as income and will tax these under income tax rules for private investors. Therefore it is best to hold them within an ISA.
Strips are arguably the most basic cash flow structure available in the capital markets, as they are zero-coupon paper. By investing in a portfolio of strips an investor is able to construct a desired pattern of cash flows, one that matches more precisely his investment requirements than that obtained from a conventional bond. For instance, if you know that you will have a liability at some point in the future, say for college fees, you can invest in strips that mature at the required time. So where private investors wish to invest for a known future commitment, they can hold strips and realise the precise amount required at their investment horizon.
RELATED GILT MARKET WEBSITES
UK Debt Management Office http://www.dmo.gov.uk HM Treasury http://www.hm-treasury.gov.uk
Bank of England http://bankofengland.co.uk
LIFFE http://www.liffe.com
London Stock Exchange http://www.londonstockex.co.uk Gilt investors http://www.gilt.co.uk
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