When gilts lose their shine: Christine Stopp explains the risks and advantages of government stock

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----------------------------------------------------------------- Top gilt trusts over three years ----------------------------------------------------------------- Income reinvested Without income reinvested Abtrust Fixed Int. 156.85 Manulife Gilt & FI 131.23 Aetna Preference 152.09 Whittingdale Short Dated 126.82 MIMStar Gilt and Fixed Int. 149.53 Whittingdale Gilt Growth 125.27 Barclays Unicorn Gilt & Fixed Int. 145.58 Abtrust Fixed Int. 121.21 Fidelity Gilt & Fixed Int. 144.72 Standard Life Gilt & Fixed Int. 119.14 Sector average 137.19 113.37 -----------------------------------------------------------------

Value of pounds 100 invested, offer-to-bid, over three years to 1 June, 1993. Source: Micropal

GILTS may be government- backed, but investors can still be stung by them.

Two cases that went to the Investment Ombudsman last year concerned gilt funds and resulted in awards totalling more than pounds 12,000. Investors had put money in on the understanding that it would be secure and were shocked to find that their capital had fallen in value.

Depending on the form in which you choose to invest, gilt funds do not always offer a guaranteed return.

Gilts can be used to provide a totally secure return, with a capital value that will not fall and an income that remains fixed for the life of the stock - but only if the investor buys the stock at or below its par value and holds it to maturity.

Jeremy Alford, of the gilt specialists Whittingdale, agrees that a gilt fund cannot guarantee a return. Gilt unit trusts rarely buy and hold to maturity. Whittingdale's view is that their funds, even after charges, can outperform a static portfolio and investments should be actively managed. Holding to maturity is not the way to get the best returns.

Because funds buy and sell stocks regularly they can make losses as well as gains. The money paid out will also tend to go up and down, broadly reflecting changes in interest rates.

Specially prone to capital losses are all-out income trusts, where the manager invests for yield, sometimes effectively buying dividends at the expense of capital.

Because it offers a higher return than interest rates generally, the market has priced it at a premium to its face value. While the yield during its lifetime will be high, the manager makes a capital loss when he sells.

Some funds, notably offshore funds such as Cater Allen Gilt Income, have developed this process to produce enormous yields, but with a heavy capital cost. The Cater Allen fund, yielding 16.3 per cent, will erode investors' capital at a rate of about 8 per cent a year. The fund is effectively a 10-year annuity, as is made clear by the managers.

Kevin Adams is the manager of the NM Gilt & Fixed Interest Fund, which abolished its initial charge at the end of May. He admits there is a conflict between high income provision and the maintenance of capital gains.

His style of management is based on a 'low risk, active' strategy, moving between shorter- and longer-dated gilts to take advantage of interest rate anomalies.

Gilt unit trusts are mainly designed to produce income, though most UK authorised funds will do their best to protect capital as well.

Fund managers are anxious to distance themselves from the capital-eroding offshore funds.

How can the investor spot the likely strategy of a gilt fund? A rule of thumb, says Mr Alford, is to check its yield against market yields quoted in the papers.

Today's highest available redemption yields are about 8.5 per cent. After an estimated deduction for fund charges, a fund yielding more than 8 per cent is probably sacrificing capital.

Mr Alford says a fund manager can capture capital gains by watching the market and selling at the appropriate moment, whereas the private investor buying such a stock and holding to maturity will make a loss.

Most investors buying at present will be locking into a loss, as almost all gilts in issue are currently trading above par.

The charges on gilt funds vary a lot - the investor might pay from pounds 10 to pounds 60 in initial charges on a pounds 1,000 investment compared with a minimum of pounds 25 or more on the same investment through a stockbroker or a mere pounds 4 through the National Savings Stock Register. Only the NSSR pays dividends gross, though they are still liable to tax.

Because of Budget tax changes the basic rate taxpayer has a slight income tax advantage in a gilt fund compared with holding gilts direct. On a directly held stock, tax at 25 per cent is deducted, whereas from next year only 20 per cent will be taken, leaving the investor with no further tax liability.

For further information on how gilts work, the booklet Investing in Gilts - a Guide for the Small Investor is free from main post offices, by calling freephone 0800 616814, or by writing to the Bank of England, PO Box 96, Gloucester, GL1 1YB.

(Photograph omitted)

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