Understanding The Stock Market
Understanding shares and the stock market also means coming to grips with safer, income-yielding savings, including gilts. In the latest in his series, John Andrew explains what this Government-backed investment is all about.

Right down at the bottom of The Independent's shares page there is a section headed Government Securities. Although they are known as gilts, the certificates, contrary to popular belief, have never been edged with gold.

The name is likely to have been coined because of their reputation, as the Government has never reneged on any gilt. However, this does not mean they are without risk, as the price of gilts traded on the stock market fluctuates.

There are two basic types of gilt - index-linked gilts (ILGs) and conventional ones. In this article we will concentrate on the latter.

There are four sub-categories of conventional gilts. Perpetuals have no set redemption date and will probably never be repaid. Shorts will be redeemed within two years; mediums from two to 12 years, while longs are redeemable anything above 12 years.

Gilts have names such as Treasury, Conversion, Exchequer or Funding. The actual name of the gilt is academic; what is important is the interest rate it pays and its redemption date. The last one listed on our shares page is Tsy 8% 21, which is shorthand for 8 per cent Treasury 2021. This means that this gilt pays an interest rate of 8 per cent - also known as the coupon - and it will be redeemed in the year 2021.

While every pounds l00 nominal value of Treasury 8% 2021 will pay pounds 8 a year for the next 25 years, the price one really pays for it will fluctuate on the market. Prices move to reflect actual and anticipated changes in interest rates. Simplistically, if interest rates rise, the price of gilts falls and vice versa.

The explanation for this is simple. The higher the interest rate, the greater must be the value of the interest paid by the gilt. This works the other way round, too. Say a gilt was issued when interest rates generally were 10 per cent. Let us call this fictitious stock Gilt 10%. One hundred pounds nominal value of the stock would produce an income of pounds l0 a year. If interest rates in the market fell to 5 per cent, Gilt 10% would still pay interest of pounds l0 a year.

Investors would then be prepared to pay up to pounds 200 for each pounds l00 nominal value of Gilt 10% as at this price it would still produce an income of 5 per cent a year (pounds 10 as a percentage of pounds 200). This is an over-simplification as the price is determined by investors' views of future rates and the redemption date of the stock.

The prices quoted for gilts are for pounds l00 nominal value. They are the middle of the buying and selling prices at the close of business on the previous business day. Look again at the entry for Tsy 8% 21 on the shares page. You will see that investors will have to pay around pounds 120 to secure pounds 100 nominal value of the stock.

The penultimate column is headed Red Yld. This is the abbreviation for redemption yield. As you will see, it is around one and a half points below the coupon rate of 8 per cent. This is because the redemption yield is the sum of all the gross interest dividends and the capital gain or loss at redemption, expressed as a percentage return per year. It is lower than the coupon rate because at redemption, investors will make a capital loss.

The booklet "Government Stock" is obtainable from all main Post Offices or by calling 0645 645 000.