What Are Government Gilts, And How Do They Work?

After the recent Autumn Budget, UK gilt yields have reached their highest level in a year. The budget, introduced by Chancellor Rachel Reeves with plans for more borrowing and spending, pushed 10 year gilt yields up by 0.09%.

Investors had a mixed response to the budget. While the tax increases of £40 billion a year initially reassured some, the plan for £30 billion in extra borrowing for infrastructure projects weighed heavily on the market. This borrowing and an increase in government debt issuance of around £300 billion are driving a sell-off in gilts, pushing yields higher.

What Are Gilts, And What Types Are Available?

In simple terms, a gilt is a bond that the UK government provides mainly investors with. When an investor buys a gilt, they’re essentially lending money to the government in exchange for interest payments and the return of their initial investment when the gilt matures. There are 2 types of gilts:

Conventional Gilts, which are the simplest form of gilts. They have a fixed interest rate, which means that investors receive the same interest payment every 6 months until the gilt matures. The government repays the full amount invested when the term ends. This fixed structure makes conventional gilts popular for those who expect predictable returns.

Index-Linked Gilts, the 2nd kind, are tied to inflation. Their interest payments and principal adjust with changes in the Retail Prices Index, so that the investment keeps up with inflation. In an economy where prices can rise, index-linked gilts can help preserve the purchasing power of the returns, so that they’re attractive to those looking to counter inflation.

How Do Interest Rates Affect Gilt Prices?

Interest rates are one of the biggest drivers in what gilt prices are. The price of gilts and interest rates generally move in opposite directions, a relationship that can help investors decide when to buy or sell.

When interest rates go up, gilt prices tend to fall. This happens because new gilts in the market will likely have a higher rate, so existing gilts with lower rates would be considered less attractive. As a result, their price goes down. If a conventional gilt has a 3% fixed rate and new gilts are issued with a 5% rate, the older gilt’s value drops because it has less interest than the newer gilts.

When interest rates go down, existing gilts with higher fixed rates become more valuable. This is because they now give better returns than newly issued gilts with lower rates. So, if rates drop and new gilts are issued at 2%, a gilt with a 3% rate becomes more appealing, and its price increases.

How Are Short-Term And Long-Term Gilt Yields Reacting Differently?

After the budget release, both short-term and long-term gilt yields have reacted, but in different ways. Yields on shorter-term gilts, like 2 year bonds, went up only slightly, and this showed the immediate market response to increased borrowing.

Short-term yields are often more sensitive to interest rate expectations, so even a hint that rates could remain higher has an instant effect on these bonds. 2 year gilt yields recently reached a four-month high of 4.41%, showcasing this sensitivity.

On the other hand, long-term gilt yields, such as the abovementioned 10 year bonds, have increased even more, hitting a one year high. This increase is a reflection of investor worries over rising government debt and prolonged high interest rates, with yields now around 4.44%.

Long-term yields are influenced by the market’s view of future economic conditions, inflation, and the demand for debt. As government borrowing is expected to rise over a few years, long-term gilt yields have steepened, signalling that investors anticipate a lasting increase in borrowing costs.
 

What Impact Will More Gilt Issuance Have On The Market?

The UK’s Debt Management Office shared that gilt issuance will be going up by £19.2 billion for 2024-2025, taking the total close to £300 billion. This increase is to fund the government’s spending plans, such as infrastructure projects and day to day public services.

A higher supply of gilts generally results in lower bond prices, as the market adjusts to the larger volume of debt available. This adjustment, in turn, raises yields as the price of existing bonds falls to match the newer, higher-yielding gilts entering the market.

Understanding Clean And Dirty Prices In Gilt Transactions

When buying or selling gilts partway through an interest period, it’s essential to know the difference between clean and dirty prices. These terms refer to how much a buyer will actually pay for a gilt.

Clean Price – the basic price of the gilt, without accounting for any interest that has accumulated since the last payment. It is the initial price of the bond.

Dirty Price – this is what the buyer actually pays, with interest added. So, the dirty price consists of both the clean price and the interest that has built up since the last payment.

Those who trade gilts between interest periods should be knowledgeable on this. If someone buys a gilt halfway through its 6 month payment cycle, they’ll pay the dirty price so that the seller is compensated fairly for the interest earned up to that point.

What Tax Benefits Do Gilts Have?

Gilts come with a few tax advantages in the UK, making them appealing for those looking to keep tax obligations low:

• Income Tax on Interest – interest from gilts counts as income, which means income tax is payable. The interest simply gets added to the investor’s taxable income for the year.
• Capital Gains Tax Exemption – profits made from selling gilts wouldn’t go towards capital gains tax for individual investors.
• Tax-Free Status in ISAs and SIPPs – those holding gilts in an Individual Savings Account or Self-Invested Personal Pension are not taxed on interest.
• No Stamp Duty – gilt transactions do not pay from stamp duty either.

How Can People Buy And Sell Gilts?

For those interested in gilts, there are 2 main ways to buy and manage them:

Through Brokers – Most individuals purchase gilts on the secondary market through a broker, just as they would buy stocks. Brokers facilitate these transactions, allowing investors to buy or sell as they see fit, based on current market conditions.

Debt Management Office – The DMO also has gilts for sale, although this is typically limited to approved members. For most people, brokers are the more convenient option to access gilts.

When buying partway through an interest period, buyers pay the dirty price, which includes the interest, so that there’s fair payment for the seller. The ex-dividend period is another timing factor to be aware of. This is a short interval before an interest payment, during which sellers retain the upcoming payment. Buyers who purchase during this period may receive a partial payment to cover the interest.