Money: A Beginner's Guide To Investing In Shares: Gilt-edged opportunit y for a sure return

Shares too risky for you? Government bonds are safer but less rewarding, says Magnus Grimond
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Shares are not the only stock market route to superior financial performance for investors fed up with paltry returns from banks and building societies. One of the more popular alternatives is the market in Government debts, known as gilt-edged securities, or "gilts". Gilts are the way the Government, via the Bank of England, has raised money to pay for schools, roads and other state projects for more than 300 years.

Gilts' enduring popularity is surprising, as they have not proved a good investment for anyone who maintains long-term holdings, as many small investors do. Figures from merchant bank BZW show that pounds 100 invested in gilts in 1945 would be worth almost the same today, after taking account of inflation and including the income paid. A pounds 100 basket of shares over the period would be worth close to pounds 3,000 in today's money.

That said, gilts have done surprisingly well recently, outperforming shares in three of the past eight years and returning a storming 29 per cent in 1993. They are likely to be outclassed by shares this year, but gilts still look on course for a respectable double-digit return.

Gilts can seem even more confusing than shares. Like any loan, the Government promises to pay interest and then repay the capital after a set term. The interest is usually a fixed amount in sterling terms - say, pounds 10 on each pounds 100 of gilts issued - paid twice a year. But, while gilts are normally issued and repaid at a fixed price and pay a set income, their price will rise or fall, as will something called the yield.

The price will rise or fall according to the perceived attractiveness of the income paid by the gilt. This in turn will depend, in part at least, on the general level of interest rates. Short-term gilts - likely to be redeemed in under five years - tend to fall in value as rates rise or if rate rises are expected, and vice versa. Longer-term issues are also affected by interest rates, but inflation tends to loom larger given the corrosive effect of a long run of rising prices on a gilt's fixed redemption value.

This risk has traditionally meant that investors demanded a higher rate of interest from long-dated issues. However, the reverse is true at the moment. This is because the market believes that the Bank of England will be tough on inflation and set interest rates accordingly, and that the UK will eventually join European Monetary Union, with its expected lower interest rates.

Like shares, gilts start life as new issues and can also be bought in the market through a stockbroker. Charges can be less than for buying and selling shares, and for small amounts it is probably best to deal through the National Savings Stock Register, through the Post Office.

The value and income from gilts is calculated by reference to nominal amounts of pounds 100 of stock, which is the value the government will repay when the bond is redeemed. Thus 15 per cent Treasury Stock 1998 payspounds 15.50 on every pounds 100 "nominal" amount of stock. Clearly, at more than double current bank base rates, this is too good to be true. So, because the income is fixed, it is left to the price of the stock to adjust to reflect prevailing money costs.

A look at the gilts prices published in the newspaper shows that Treasury 15 per cent stock is trading at pounds 1067/32 for every pounds 100 nominal. Divide the pounds 15.50 received into the price and you arrive at the running or flat yield, which happens to be 14.59 per cent. Still a decent income, but a buyer at the current price will lose pounds 6.22 in every pounds 100 if he holds the stock to redemption next year. The redemption yield takes this loss into account. The newspaper shows the redemption yield standing at 7.24 per cent: not surprisingly, close to what you might get from a building society savings account.

These capital gains and losses are important for the taxpayer, because capital gains on gilts are tax-exempt. So gilts which are at a discount to nominal value are valuable for anyone who may incur capital gains tax, as they provide a guaranteed tax-free capital gain at redemption.

Perhaps even better value for higher-rate taxpayers are index-linked gilts. Capital and income are protected from rising prices, so the capital return can be even better than on a conventional gilt. But inflation has been low in recent years and index-linked gilts have underperformed equities, conventional gilts and even cash since they were introduced in the early 1980s. They may do better if higher inflation returns, but the omens are not good.

As the government's finances improve, the stock of gilts in the market is dwindling. With over pounds 270bn in issue, gilts are already dwarfed by the pounds 4,000bn tied up in equities. Further shrinkage in the supply should be good news for prices, while the introduction of gilt "strips" may add to the their attraction. Strips essentially break up a gilt into its separate payments of interest and capital and turn them into mini-bonds which can be traded separately. They may be attractive for people seeking income in retirement or for school-fee planning.

For the cautious investor who needs certainty of income, gilts are a reasonable bet. The index-linked variety should also prove a secure hedge against inflation. But you can lose money in gilts. They are a useful adjunct to the portfolio, perhaps, but shares remain the better bet.