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The UK government has been issuing gilts since 1964. Don’t let the fancy name fool you; gilts are just bonds issued by the British Government. Their sole purpose is to help the government raise money for different projects and initiatives. Generally, depending on maturity, gilts are classified into short-term, mid-term, and long-term securities.
If you are an investment enthusiast, consider adding gilts to your portfolio. Why? For starters, they offer attractive returns and are less risky, more so since the UK government has never failed to pay gilt holders. But before investing in these securities, there are certain things you should know. We’ve covered them below.
In This Guide
Impact of Interest Rates on Gilts
The prices of gilts and interest rates are inversely proportional. In other words, when gilt prices rise, interest rates fall. Here’s how this works. Most gilts have fixed interest rates.
Suppose the Bank of England decides to increase interest rates today. In that case, all new government bonds will come with the new, higher rates. Consequently, more investors will prefer the new bonds because they offer juicier returns, meaning older gilts will be less attractive. To address that, authorities reduce the prices of older government bonds in a bid to force their yield to align with the higher interest rates. That is why we said these securities have an inverse relationship.
How high or low the prices of gilts will go in response to changing interest rates depends on the types of gilts involved. Let’s explore that in deeper detail, keeping in mind that there are three broad categories of gilts: short-term, medium-term, and long-term government bonds.
- Short-term gilts: These are the least responsive to interest rate changes. Since a short time frame is involved here, shifting interest rates don’t have a significant impact on investors’ total returns.
- Medium-term gilts: The prices of medium-term gilts, whose maturity is around 4-10 years, are more responsive to changing interest rates compared to short-term gilts. However, their vulnerability can’t be compared to long-term gilts.
- Long-term gilts: Changing interest rates have the most pronounced effect on long-term gilts. In other words, even what would seem like an insignificant adjustment in interest rates can have an immense effect on long-term gilt prices.
Risks of Gilts
Since gilts are backed by the government, they are ideal for people searching for low-risk securities. That said, even UK government bonds come with their fair share of risks. We’ve explored some of them below.
- Interest rate risk: As we mentioned earlier, the interest rate changes impact the prices of UK government bonds. This can be a good thing since decreasing interest rates can cause an increase in gilt prices. Sadly, the opposite is true: the prices and value of older gilts often decrease in tandem with rising interest rates.
- Inflation risk: Inflation erodes the value of yields or coupons that gilt investors receive. People who invest in long-term government bonds face a greater inflation risk than their counterparts.
- Duration risk: As you already know, the sensitivity of government bonds to changing interest rates increases as you move from short-term to long-term gilts. Bonds with the highest durations are the most sensitive to interest rate changes, and their prices can drop by a shocking margin when rates go up.
- Credit risk: This points at the possibility of the government failing to fulfill its obligation to gilt holders. In other words, while investing in gilts, you must keep in mind that, although the chances are extremely low, the UK government might fail to repay your principal amount or yields when your bond matures. But don’t fret; the UK government has never failed to meet its obligation to gilt holders.
- Currency risk: This exclusively applies to foreign investors. Anyone living outside the UK will receive interest payments in British Pounds. And while converting GBP to their home currency, fluctuating exchange rates can immensely impact the value of the investment in context.
- Liquidity risk: Despite gilts being relatively liquid securities, there’s still a risk of gilt holders being unable to sell their bonds promptly whenever necessary due to a shortage of buyers.
- Political risk: Elements like political instability and changing government policies may significantly impact the economic environment and reduce bond prices or affect the UK government’s ability to pay investors.
Current Market Outlook for Gilts
In October of 2024, Chancellor Rachel Reeves announced tax increases considered the highest since 1993, according to a Reuters report. The Chancellor also proposed increased borrowing to address the enormous UK public sector’s current budget deficit. These elements have catalyzed a significant surge in gilt yields. That translates into high returns for existing investors, which is good news.
Due to the aforementioned mandates, the yield for the 10-year gilt has risen by over 0.1% and is now approximately 4.45%. On the other hand, the 2-year gilt’s yield is now 4.42%, meaning it has increased by around 0.18%.
Conclusion
Gilts are ideal for conservative investors seeking to hedge against inflation and market volatility or increase income. However, before putting your money in these assets, you must understand the relationship between interest rates and gilt prices. We’ve explained everything in this piece. Just to recap, rising interest rates cause lower gilt prices, and vice versa. Also, before buying UK government bonds, research how yields vary from short-term to long-term gilts.