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Safety-first investors set out on a gilt trip

Government bonds may be safe, but would you be sorry about the returns? asks Sam Dunn

As investments go, they don't come any less sexy than gilts. Bonds backed by the government just aren't glamorous; without exposure to volatile stock markets or racy companies, there are no glittering returns.

As investments go, they don't come any less sexy than gilts. Bonds backed by the government just aren't glamorous; without exposure to volatile stock markets or racy companies, there are no glittering returns.

On the other hand, they're safe. The only way investors can lose their money is if the British government goes bust and defaults on its debts. But, despite such crises over the years as the three-day working week and the IMF intervention during the 1970s, the government has never failed to honour its obligations.

As a general rule, UK gilts carry the same low risk profile as cash, although they don't offer the same easy access in an emergency. An abbreviation of "gilt-edged" stock, they derive their name from a reputation as one of the safest investments around, which explains their appeal to pension funds.

After you pay a lump sum to buy a gilt holding, you receive a twice-yearly fixed dividend based on the gilt's face value. Your capital is also guaranteed, as long as you hold the gilt until maturity. For good measure, at extra cost, you can protect yourself against inflation by opting for index-linked gilts.

"In terms of safety, they are a few notches above blue chip company bonds," says Justin Modray, investment manager at independent financial adviser (IFA) Bestinvest. "But a good, actively managed corporate bond fund can get better results without a significantly higher risk."

Gilts' lack of dynamism may not appeal to many investors but their reliability earns them a place in some portfolios as a way to reduce risk, particularly if you have spicier investments in emerging markets, say, or Japan.

The annual income offered by a gilt would be its chief appeal, says Meera Patel, senior analyst at IFA Hargreaves Lansdown, yet the fierce competition from both savings accounts and mini cash individual savings accounts (ISAs) is hard to resist.

"Cash is king," says Ms Patel. "There are such competitive rates out there - Halifax offering 4.8 per cent, for example [on its fixed mini cash ISA]. And with interest rates having increased, you can expect things to heat up even more."

As an example of how gilts work, a £1,000 holding of Treasury stock 2010 at 6.5 per cent means that, in six years' time, you will get a £1,000 lump sum back from the government. Until then, you will receive £65 every 12 months as dividends (6.5 per cent of £1,000).

Yet you may not have to pay the gilt's cover price in order to buy it. Like other investments, government bonds can be traded once they have been issued, and the laws of supply and demand will decide their price. Much depends on how attractive the rate of interest is compared to offers available on other products; the length of time until redemption; and expectations of future interest rates, says Mr Modray.

"Gilt prices can change on a daily basis and many investors do buy [on the market rather than at issue]," he says. "Be aware that if you trade it ahead of its maturity, you could make a loss - or a gain, of course."

Using the example above and the possibility of earning 8 per cent on an investment elsewhere, the gilt's annual 6.5 per cent dividend no longer seems so attractive. To reflect this, the price would typically drop if you wanted to sell it, though it would continue to pay you £65 a year. But you wouldn't lose out if you held on to it until maturity.

Such complexity can be offputting: "barely 230 private investors turned up to buy at a recent gilt auction," says a spokeswoman for the Debt Management Office, an executive Treasury body that authorises new gilt issues.

However, gilts do offer some advantages. While you have to pay income tax on the dividend interest, any profit on the sale of a gilt is free of capital gains tax. And there is no stamp duty to pay when you sell.

If you feel a gilt investment might suit your portfolio, you can buy one from stockbrokers, high-street banks and via the Bank of England's website. Expect to pay commission (0.7 per cent via the Bank's brokerage service) and, if you buy through a stockbroker, an annual fee.

Alternatively, you could opt for a general fund that invests in gilts. The advantage of this is that you will be exposed to a wider number of gilts.

Over three years, the sector's average growth has been 12.1 per cent, compared to an 11.43 per cent fall in the UK Equities sector, says ratings agency Standard & Poor's. This is no surprise given the plunging stock markets during this time, but gilts were outpaced by corporate bond funds, which grew, on average, by 17.49 per cent.

Contact: Bank of England, 0800 818614, www.bankofengland.co.uk/registrars