Gilt stocks maintain their edge

With the threat of gains tax lifted, people seeking income are still on to a good investment
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The Independent Online
NOT LONG ago, a senior sales manager in a leading London institution selling investment products went to lecture wealthy potential investors in a small Hampshire market town. He soon realised his attempts to describe the attractions of investing in gilts were causing furrowed brows.

To him a gilt is a fixed-interest stock or bond with a nominal value of pounds 100, issued by the UK Treasury and paying a set rate of interest each year, until it matures at a fixed future date and is repaid at pounds 100. Uniquely among financial investments, capital gains on gilts have been exempt from tax. Repayment is also guaranteed in full to the holder of the stock, hence the title gilt-edged stocks, or gilts.

The majority of his audience, however, were under the distinct impression that a gilt is, ahem, a maiden pig. Yet this is a market containing around 70 stocks, with a market value around pounds 227bn at the last calculation.

Several hundred thousand private investors do hold gilt-edged stocks, and they are meant to be throwing their hats in the air this weekend, after being exempted from the Treasury's plans to tax their capital gains as income in future. Anyone with a portfolio of government stocks worth less than pounds 200,000 will continue to be exempt from capital gains tax.

Only big corporate investors will now have their gains taxed as income in future, since pension fund managers are exempt from tax on their investments anyway, and managers of corporate bond PEPs, unit trusts, and investment trusts have also been given the nod that they will not be put at a disadvantage.

Nothing has actually been done to make investing in gilt-edged stocks more attractive to private investors than it has been. No investor should really buy a gilt until he or she has bought the annual allocation of corporate bond PEPs, which are free of both income and gains tax. But after that, the yields on gilts, which are currently up to twice the return on the average equity or company share, still make them attractive to investors looking for income. Any broker will buy and sell gilts, and a variety of stocks can also be bought and sold over Post Office counters, at special low dealing rates.

Each gilt pays a set rate of interest each year on each pounds 100 nominal portion of stock. This amount is known as the coupon. But the attractiveness of a set return varies continuously with the level of competing interest rates and inflation in the economy, so the market price of the stock, once issued, will vary continuously. A stock issued with a coupon of 8 per cent will fall in value if the going rate of interest rises, and rise if rates generally fall. At a price of pounds 95, a gilt with an 8 per cent coupon will give a new investor a yield of 100/95 x 8 = 8.42 per cent. But at pounds 105, the yield would be 100/105 x 8 =7.62 per cent. This is known as the "flat", "interest" or "running" yield.

"Undated" stocks such as 3.5 per cent War Loan, originally sold to finance the First World War, have no set redemption date, and it looks increasingly likely that they will never be repaid, so investors are simply buying income. But the great majority of gilts have a finite life, and regardless of the price at which they are first issued or currently traded, they will be repaid at par, ie pounds 100 per unit.

This means stock bought below par will produce a guaranteed capital gain, and, conversely, stock bought above par will show a guaranteed capital loss, if they are kept until they mature. Including this capital loss or gain allows investors to calculate a gross redemption yield, ie the total return in income and capital from now until maturity, annualised over the remaining life of the stock. The formula, allowing for accrued interest in the current price and for the years, months and days until maturity, is a daunting one, but the end result is detailed in the press.

Prices are still quoted in fractions. As interest rates have fallen, most older stocks now stand at a premium. So, for example, Treasury 13 per cent maturing in 2000 was trading at pounds 120 27/32 early last week. At that price, the pounds 13 of annual interest gave a running yield of 10.76 per cent of the current price, but allowing for the inbuilt capital loss over the next five years reduces the yield, if held to redemption, to 7.85 percent.

When Eddie George joined the Bank of England, managing the gilt-edged market was the Bank's main task. It still acts as agent for the Treasury and has frequently issued stock with an artificially low coupon at a substantial discount, knowing that investors liable to top rates of income tax were more interested in capital gain when a stock bought at a discount matures than in income. There are still a handful of stocks trading at a discount, and top-rate taxpayers have clearly still been buying them for the tax- free capital gain rather than the income. These investors would have been most affected if the Inland Revenue had effectively been allowed to change the rules.

Gilts, like all fixed-income stocks, have no defence against inflation, and in the 1970s and 1980s the Treasury resorted to issuing a number of index-linked stocks whose capital value and coupon is adjusted in line with rises in the retail price index, after a time-lag of eight months or so. By definition all these stocks generate capital gains through inflation, and would also have suffered heavily if capital gain became taxable as income.