How gilts work and why they matter

In this week's video, Ed Bowsher takes a look at UK government bonds - how they work, why they are important, and whether you should invest in them.

If you invest in a gilt, you're lending money to the government and in return getting an IOU.

The government lends gilts all the time when they need to borrow more money. For example:The government issues this new guilt:

4% treasury guilt 2038.

You invest £1000 in this new guilt, the government pay you £40 a year, probably in two installments of £20 twice a year, called a coupon.In 2038, you will get your £1000 back.

If you want to get your money back early, you can sell your gilt on the financial market just like stocks and shares. But just like stocks and shares the price of gilts changes.If you want to sell your gilts, and, for example, could only get £900 for your guilt, the new investor who bought your guilt will still get £40 a year and will still get £1000 in 2038. The investor's yield will be 4.44%, plus the £1000. This is called a running yield.

On the other hand, the value of the gilts could rise; you could sell it for £1100. The running yield would then be lower, at 3.63%, and you'll make a loss on your capital as well, because you invest £1100 and only get £1000 back.

Why do guilt prices move and change on the markets? This is down to what people are expecting to happen to inflation and interest rates in the future. If people expect interest rates to rise, they price of gilts fall, because the lower return is not as attractive.

People invest in gilts because they are normally seen as a safe and are predictable investments. The government has never defaulted on any gilt and any gilt that has been issued, people have always got that coupon, £40 a year, and they've always had their money back at the end of the bond's term.

Some people say given what's happened over the last few years with the financial crisis, perhaps gilts aren't quite as safe an investment as people once thought, but I'd still say they're a pretty safe investment.

The other attraction is the regular predictable income, particularly for people who are retiring, for pension funds. Regulations now insist that pension funds invest substantial chunks of their assets into gilts.

Another interesting point is that gilts have performed exceptionally well over the last twenty years. Mostly because inflation and interest rates have been low, and in that environment gilts do well. More recently we've had a situation with quantitative easing; the government has been printing money to buy gilts, so that's pushed up the price, and pension funds have been keener to buy gilts and get that safe income, and the regulators have been telling them to buy gilts.

These are all reasons gilt prices have got so high and gilt yields have got so low. Because of this, Id be a bit reluctant to invest in gilts now, if you went on the finance market today and wanted to buy a gilt that matures in 10years time, you're only going to get a yield of 2.6%. I really expect interest rates will go up in the next few years, so gilts paying 2.6% won't look terribly attractive down the line.

So for most people I'd say gilts aren't a great investment now.

But you should still understand how gilts work and keep any eye on how they work, because they still affect you one way or another, even if you don't buy any.

Gilts affect mortgage rates, especially fixed rate mortgage rates. They affect how much income you get in your retirement if you have got a private pension pot. If you're going to use that pension pot to buy an annuity when you retire and get an income, if gilts yields are low, the annuity you get on your pension pot will also be low. If gilts yields are low that means the government are borrowing cheaply, so that's a big advantage, so a smaller proportion of your taxes are going towards interest payments so the government can use the money for other things.