Like most others, the UK government borrows money by issuing bonds. In the UK, these government bonds are called gilts.

The name ‘gilts’ hints at their antiquity. Back in the day, gilts were pretty certificates with gold-leaf trimming. These certificates are the origin of the phrase gilt-edged security.

Today gilts are bought and sold electronically. Given that the cash-strapped British Government has been raising more than £200 billion a year by auctioning off new supplies of gilts, that development is perhaps to the relief of postmen across The City.

Back in 1997, the entire stock of outstanding gilts was a mere £275 billion! By October 2010 it had surpassed £1,000 billion.

Gilts are the safest form of UK investment

An investment in gilts has long been considered about as safe as investing gets. The British Government has never defaulted on its debts in its several hundred years of raising money. Only US Treasuries and the bonds of a few other countries are considered as secure.

This perceived security is reflected in the UK’s AAA-rating for its debt. The AAA-rating has so far survived even the sharp deterioration of the UK’s financial strength in the wake of the credit crisis and recession of 2008/09, as well as quantitative easing.

The UK Treasury (via the Debt Management Office, or DMO) has skilfully taken advantage of our excellent reputation by issuing gilts with a very long life. Gilts have been issued with as long as 50 years to run until they’re redeemed.

Investors will only buy such long-dated securities if they’re confident the government will still be honouring its debts in 50 years time!

The UK has its own currency, of course, which in principle makes paying its debts a formality – unlike you, me, or a company, the government can simply print money to meet its debt payments.

Investors in gilts aren’t idiots, though, and they’re well aware of this. The trust placed in gilts isn’t just that the UK government will honour its debts in full, but also that it will manage the public finances in such a way that high inflation won’t erode the value of their investment.

The average maturity of UK gilts is around 14 years. This is the main reason why we have so far avoided the sort of sovereign debt panics that struck Greece and Ireland. The markets can take a sanguine view, knowing we’ve years to come up with the money to pay out debts.

Gilts: The basics

If you buy a gilt when it’s issued for exactly its nominal value and hold it to its redemption date, you know exactly how much money you’ll get over the years.

• You’ll be paid the interest rate (the coupon) every year plus you’ll be repaid the nominal value of the gilt when it matures.

For instance, a gilt called Treasury 5 pc ’30 will pay £5 a year until 2030 for every £100 nominal (also called the face or par value) that you buy and hold.

Gilts are generally sold by the government for a little more or less than their nominal value, however.

• The price investors pay for new gilts is determined by an auction. This means they may pay more or less than the nominal value (say £101 or £99), which reflects the annual yield they’re demanding for holding the gilts.

• If investors pay more than the nominal value to own the gilt, they’re accepting a lower yield. And vice-versa.

• The coupon payment is split across two payments a year.

When the redemption date is reached, the government pays you back the nominal value of the gilt. This makes it almost impossible to lose money with gilts in cash terms, provided you hold until redemption and the government doesn’t default, though inflation can easily erode your real returns.

Note that this doesn’t mean you’ll necessarily get back what you paid for your gilts. You might pay £105 in the open market, and receive just £100 back when the gilt is redeemed. However this capital loss will have been taken into account by the market and reflected in the income you’ve received for holding the gilt. This total return is the key.

Some gilts are undated. For instance, there’s a nearly 100-year old gilt called War Loan 3 1/2 pc.

Undated gilts payout their coupon forever. They can be considered a bet on very long-term interest and inflation rates.

Gilts are traded, which introduces risk

Once issued by The Treasury, gilts can be bought and sold on the secondary market until they mature, just like shares and other securities.

An easy way to think of how their price fluctuates is to imagine what you’d pay to own the aforementioned War Loan 3 1/2 pc:

• What would you pay if interest rates on savings were 6%?

• What would you pay if interest rates on savings were 2%?

All things being equal, an investor would obviously pay more for a 3.5% coupon when interest rates on cash are lower than that, and substantially less when interest rates on cash are higher.

The investor’s calculation is complicated by the fact that an undated gilt is never redeemed. This means his view of interest rates (and inflation, and UK solvency) must extend far into the future.

Dated gilts are less risky investments. You know you’re going to get the nominal value back (not the price you paid, remember!) when they are redeemed, regardless of how their price fluctuates in-between. This makes it possible to calculate a yield to redemption, which takes into account both the annual coupon you’ll be paid for owning the gilt, and the capital gain or loss you’ll make when the gilt is redeemed.

This assumes you hold the gilt until it’s redeemed, of course. If you sell it before then, you might make a trading gain or loss.

You don’t have to calculate redemption yields and so on for yourself. Prices and yields are listed in newspapers like the Financial Times, and on websites like Fixed Income Investor.

A few other useful things to know about gilts

• The interest payment from gilts is treated as taxable income.

• Any capital gains that arise from disposing of gilts are tax-free.

• You can buy gilts directly through your broker or invest via a fund.

• Gilts can go in an ISA provided you buy them with five years until redemption.

• Index-linked gilts are a special kind that offer inflation-proofing. Both the coupon and the principal payment are adjusted in line with RPI. You might not get much on top of that though, depending on the mood of investors when you buy.

Further reading on bonds

I have written extensively about bond pricing and yields on Monevator in the context of corporate bonds. Gilts are priced and traded in exactly the same way, only the risk of default is far lower.

Here’s some articles to help you understand more about bonds:

• How to calculate bond yields
• What causes bond prices to fluctuate?
• Where to find bond prices and yields
• Government bonds and asset allocation

For yet more information on gilts, check out the DMO’s official lowdown on gilts.

Tracking error is often cited as a key factor in tracker fund selection. Tracking error is to tracker funds as goal tally is to a Premiership striker – a fundamental measure of how well the job is being done.

A tracker’s role is to deliver the returns of its benchmark index. In an ideal world, if the FTSE All-Share index returns 10% a year, then a FTSE All-Share tracker will also return 10%. But the world is rarely perfect (mine isn’t anyway), and tracking error shows just how wide of the (bench) mark the performance is.

That’s important information for passive investors because it can reveal the hidden cost of owning a tracker. There’s no point choosing a fund with a Total Expense Ratio (TER) 0.2% cheaper than its rivals, if its returns consistently lag the same benchmark by an extra 0.5%.

What exactly is tracking error?

Like so many investing terms, there are many different versions of tracking error and ways of calculating it. It’s therefore often difficult to be sure that two different sources are talking about the same measure.

That said, a reasonably common definition of tracking error is:

Tracking error = the standard deviation of returns relative to the returns of the index.

The lower the tracking error, the more faithfully the fund is matching its index.

When comparing funds, choose the lowest tracking error possible. A tracking error above 2% indicates the fund is doing a bad job.

What causes tracking error?

An index tracker is like an impressionist. It mimics its benchmark but can never quite be a dead ringer, chiefly because of:

• Costs

Index returns aren’t dragged down by operating expenses, but tracker fund returns are. Therefore you’d always expect a fund to lag its benchmark by at least its TER. The TER is deducted from the fund’s net asset value (NAV) on a daily basis, so the lower the TER, the lower the tracking error, and the better the expected fund return, all things being equal.

• Replication

Full replication funds that hold every stock in their index should offer zero tracking error as they are the index. (Except that transactions costs incurred when rebalancing ruin the beautiful dream).

Partial replication funds that sample a portion of their benchmark’s securities (because the cost of holding them all is too high) will inevitably generate tracking error, being only a representation of the index rather than a perfect clone.

Synthetic funds use swap-based contracts to guarantee they match their indices’ performance. But the swap fees and collateral costs incurred by the contracts drag down fund performance against the benchmark.

Taxes and transaction costs like brokerage fees and trading spreads add to our tracking error woes, no matter which replication model is used.

• Turnover

The more trades a fund makes, the greater the trading costs, which ultimately undermines performance and adds to tracking error.

• Management experience

Although index funds are popularly thought to be so simple that they can be run by VIC-20 computers, better management can rein in tracking error. Look for funds with a long record of tight tracking error.

• Enhancements

This one actually works in our favour. Funds can earn extra revenue that closes the performance gap (or even turns it positive). Typically this income comes from two sources:

1. Fees earned by lending out fund securities to short-sellers.
2. Dividend enhancement – lending out securities to tax-benign territories when dividends pay out.

Now what?

So that’s tracking error in a blog-style nutshell. And everything would be hunky dory if fund providers published tracking error on their factsheets just like TER. But they don’t, and there’s no regulatory requirement for them to do so.

Clean comparisons of funds by tracking error are nigh on impossible in the real world. You might work tracking error out for yourself, if you love equations, but that doesn’t sound like many couch-potato investors I know.

Instead, you can use tracking difference as a substitute for tracking error when you want to compare rival funds.

Take it steady,

The Accumulator

This week’s best post from elsewhere, plus more good links from around the Web.

Anyone who read my post on house prices predictions may have sensed my enduring frustration with the London property market.

If you thought cockroaches were hard to kill, you should try stamping out house price inflation in desirable streets in Zone 2.

London prices will always be high, absent a dirty bomb. The question is are they justifiably tear-jerkingly elevated, or are they pricey even for loaded Londoners?

To investigate, I was all set to produce some pretty graphs as a follow-up. But then I noticed The Finance Blog has sprung back into life and done it for me.

I’m all about the 80/20 rule of time management, so my Post of the Week comes from the Finance blog!

Here’s its crunching of the current house-price to earnings ratio:

Perhaps its wishful thinking, but to me the London ratio looks like a trend reverting to mean, interrupted by emergency interest rates in March 2009.

Alternatively, perhaps the recovery in equity markets resurrected London house prices by reflating bankers’ bonuses? I say that because the North has only flat-lined, despite the deluge of cheap money (for those who can access it).

The Finance blog also has useful graphs on affordability, and on the percentage of FTB pay that goes on a mortgage. Property addicts should go check it out.

[continue reading…]