Governments issue bonds to close a gap between expenditure and revenue. UK public sector (central and local government) collect taxes from its citizens to spend on a country's infrastructure, education, health facilities, and other social and economic projects. When the expenditure exceeds the revenue, governments must borrow money to cover the budget deficit, and it is mainly done by issuing bonds. The year-on-year accumulation of budget deficit results in the national debt, which Abel et al. (2017) describe as the total value of government bonds outstanding at any particular time because the fiscal deficit should equal the total amount of a new borrowing to cover the difference in the budget. The amount borrowed annually by the UK government is often referred to as the public sector net cash requirements (PSNCR).
As of March 2020, the UK debt equalled £1,876,800,000,000 or £1.87 trillion. For every person that lives in the United Kingdom, the government owes on average £27,546. The national debt is equivalent to 84.6% of gross domestic product (GDP), and it is likely to rise due to the government's heavy spending to cope with the Covid-19 pandemic. In the fiscal year of 2017/18, the total public sector net borrowing was £17.2 billion, while at the peak of the Great Recession of 2007-09, it was a staggering £153.1 billion, an equivalent of 9.9% of UK GDP at the time. In addition to these 'net borrowing' amounts, the UK government issues new debt instruments to raise enough money to repay an outstanding debt that becomes due. Thus, according to Arnold (2015), the gross borrowing or gross issuance is actually much larger – of the order of extra £50-60 billion per year. It makes perfect sense if we say that the fiscal deficit should equal the total amount of a new borrowing to cover the budget difference, given that the UK's budget deficit in March 2020 was approximately £60.3 billion.
Figure 1. Public Sector Net Borrowing. Source: ONS
UK Gilts: The Definition and Issuance
Gilt-edged security or simply gilt is the UK debt security issued by the Debt Management Office (DMO) – the executive agency of Her Majesty's Treasury, responsible for the debt and cash management for the UK Government. The term 'gilt' refers to the primary characteristic of gilts as an investment: their security. The UK Government has never failed to pay interest and return the principal to its investors. Arnold (2012) defines a bond as:
''… a long-term contract in which the bondholder lends money to a company, government or some other organisation. In return the company or government, etc. promises to make predetermined payments (usually regular) in the future which consist of interest and a capital sum at the end of the bond’s life (maturity).''
Since April 1998, the Debt Management Office has been the gilts' issuer due to the reorganisation within the Bank of England, whose duty was to issue government bonds before the DMO took this responsibility. A summary of UK gilts and money markets operations is published by the Debt Management Office every three months in ‘Quarterly Reviews[1]’. Gilts are issued via auctions with a par value of £100 together with a coupon, i.e., an amount of interest an investor will earn each year on the nominal value. For example, the coupon with a rate of 4.25% suggests that investors are entitled to receive £4.25 for every £100 nominal they own of the gilt each year (CISI, 2020). In most cases, interest is received semi-annually in two equal payments on fixed dates six months apart. In our example, half of the £4.25 will be paid to an investor twice a year. The nominal value of the bond is effectively the amount borrowed by the Government. The prices of bonds will fluctuate on secondary markets subject to several factors, most notably the prevalent interest rate set by the Bank of England, also known as the Bank Rate.
If a private investor wishes to purchase gilts, the secondary market can be accessed through a stockbroker, bank, or the DMO's Purchase and Sale Service, operated by Computershare Investor Services plc, who are also responsible for maintaining the register of gilt holdings. The DMO offers an "execution-only" service for private investors who are members of the DMO's Approved Group of Investors to buy and sell gilts. Moreover, gilts can be traded through a gilt-edged market maker (GEMM), a primary dealer in gilts. It actively trades in either conventional gilts, index-linked gilts, or both. The full list can be accessed on the DMO website here. Gilt-edged market makers include divisions of major UK and international banks, such as Barclays, BNP Paribas, Banco Santander, Deutsche Banks, Goldman Sachs or JP Morgan.
Classification and Types of Gilts
Conventional gilts are one of the two major types of debt securities traded in the gilt market. Otherwise known as a bullet or plain vanilla bonds offer a fixed rate of interest shown in the gilts' title, e.g., HM Treasury % Treasury Stock 2032. The government returns the principal upon the maturity date. In our case, it is 7 June 2032. The DMO describes conventional gilts in the following way:
''Conventional gilts are the simplest form of government bond and constitute around 75% of the gilt portfolio. A conventional gilt is a liability of the Government which guarantees to pay the holder of the gilt a fixed cash payment (coupon) every six months until the maturity date, at which point the holder receives the final coupon payment and the return of the principal. The prices of conventional gilts are quoted in terms of £100 nominal. However, they can be traded in units as small as a penny.''
Index–linked gilts (linkers) are the second most popular type of bonds issued by the UK Government. The first-ever index-linked gilts were issued on 27 March 1981 in a £1 billion nominal offering (CISI, 20202). As with conventional gilts, the coupon on an index-linked gilt reflects borrowing rates available at the time of the first issue. However, as index-linked coupons reflect the government's real borrowing rate rather than the nominal borrowing rate, there is a much smaller variation in real yields over time (the DMO, n.d.). Semi-annual coupon payments and the principal are adjusted in line with the UK Retail Prices Index (RPI), an index used by the Bank of England to measure the rate of inflation, i.e., changes in the prices of a basket of different goods and services which the average person is assumed to spend their money on (CISI, 2020). The RPI is published monthly by the Office for National Statistics.
New index-linked gilts issued from September 2005 employ the three-month indexation lag structure first used in the Canadian Real Return Bond market and not the eight-month lag methodology used for index-linked gilts issued before that date.
Gilts are classified in terms of their maturity, i.e. the time left until the redemption date. According to Arnold (2015), UK authorities define maturities of gilts as:
ultra – short conventional; up to 3 years
short conventional; 3-7 years
medium conventional; 7-15 years
long conventional; 15-50 years
ultra - long conventional; over 50 years
index-linked; various
undated
Slightly different classification is provided by the Financial Times.
shorts; under 5 years
mediums; 5-15 years
longs; over 15 years
However, gilt dealers on the London Stock Exchange (LSE) and the DMO suggests yet another way of classifying gilts in terms of their maturity:
shorts; under 7 years
mediums; 7-15 years
longs; over 15 years
Remember that the classification of bonds in terms of their maturity is not based on their total lifespan but on how long they have to run before the government must repay the principal upon its maturity date. Using the LSE and the DMO method of classification, the treasury bond issued in 2000 with the redemption date in 2030 is a long gilt until 2015 because the time left to redeem it is greater than 15 years up until this point. A year later, however, it would be classified as mediums (<15years till redemption date), while from 2027 and onwards, it would be considered shorts.
In addition to conventional and index-linked gilts, floating-rate gilts pay variable coupons four times a year (every quarter). The coupon is set by reference to LIBID at the beginning of each interest payment period (CISI, 2020). The DMO does not issue floating-rate gilts. Convertible gilts allow the bondholder to convert the gilt into a predefined amount of another type of gilt at some time in the future. Convertibles tend to be short- to medium-term bonds that may be converted into a longer issue at the investor's discretion (CISI, 2020).
UK Gilt Market: At a Glance
The size of the gilt market is dependent on the Government's debt. By the end of December 2020, gilts account for approximately 86% of the UK debt portfolio, or £1.82 trillion. The DMO issues Treasury bills on behalf of the Government. These are short-term instruments (<1 year) traded in money markets. Treasury bills represent 3% of the total UK debt portfolio. Moreover, the Government offers a wide range of investment products via its executive agency, National Savings & Investment. An investor holding an NS&I product is, in essence, lending to the Government.
Figure 2. Composition of central government sterling debt in % and £ billion (end-December 2020. Source: HM Treasury. Published in March 2021.
In the last Quarterly Review for the period between July and September 2020 (published on 24 November 2014) there was a total of 78 gilts in issue:
17 short conventional gilts;
10 medium conventional gilts;
23 long conventional gilts;
25 index-linked gilts with a 3-month indexation lag; and
3 index-linked gilts with a 8-month indexation lag.
By end of December 2020, the average maturity of the total stock of gilts was 15.3 years as shown in figure 3. The average maturity of the stock of conventional gilts had dropped from 14.3 years at the end of 2019 to 14 years at the end 2020. The average maturity of the government’s wholesale debt remains consistently longer than the average across G7 group of advanced economies: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.
Figure 3: Average maturity of UK gilt stock. Source: HM Treasury
UK Gilts’ Taxation
Interest on UK gilts is paid gross; thus, no tax is deducted at a source. Coupons are subject to income tax. It is an investor’s liability to declare the income on tax returns. However, investors may choose to have the income tax at the rate of 20% deducted from the payment on their coupons. It is referred to as electing for withholding tax to be deducted.
Individual investors may hold gilts in stocks and shares ISAs, and those who are residents in the UK can subscribe up to the relevant ISA limit for the financial year in question. Income and capital gains from investments held in ISAs are exempt from income tax and capital gains tax and should not be shown on tax returns (the DMO, n.d.).
The taxation, however, is a complex matter; thus, a detailed analysis of UK gilts’ taxation rules is beyond the scope of this article.
Any thoughts?
Bond and money markets are vital parts of any well-functioning economy. In particular, government bonds or UK gilts are essential in covering budget deficits, which directly result from insufficient income raised through taxes relative to public spending. Year-on-year budget deficits accumulate into the national debt.
UK gilts are considered a very safe form of investment, as the British Government has never failed to make any payments to its lenders on issued gilts. According to the Standard’s & Poor credit rating agency, the UK has a very strong capacity to meet financial commitments (‘AA’). The UK had been previously awarded the highest investment grade of ‘AAA’ with an extremely strong capacity to meet its financial commitments. However, it was downgraded to ‘AA’ shortly after the Brexit vote in 2016. In addition to the safe returns investors expect, bond markets are generally highly liquid. It means that gilts can be bought and sold in a reasonably quick time. Bonds are the basic ingredient of the world’s debt capital markets, which in turn are the cornerstone of the economy. A country’s economic strength will be reflected in the value placed by the financial markets on its government-issued borrowing instruments (Arnold, 2015).
[1]Quarterly Review - a short document takes the form of a series of charts and tables and includes statistics on the gilt portfolio, movements in gilt yields, gilt market turnover statistics, distribution of gilt holdings statistics (produced by the Office for National Statistics (ONS) and an update on the DMO's financing remit.Bibliography
Arnold, G. (2015). FT Guide to Bond and Money Markets. [ebook] Pearson. Available at: https://www.perlego.com/book/398192/ft-guide-to-bond-and-money-markets-pdf
Debt Management Office (n.d.). Publications: Gilt Market [online]. Available: https://www.dmo.gov.uk/publications/gilt-market/
Chartered Institute of Securities & Investment (2020). Investment, Risk & Taxation, 11th edition. London: CISI
HM Treasury (2021). Debt Management Report: 2021-22 [online]. Available at www.gov.uk
Office for National Statistics (2020). Government, Public Sector and Taxes [online]. Available at: https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes