Why the Interest in Gilts?

Why the current interest in 'Gilts'? The answer to this question is that issuing such securities is the main way in which the government borrows, and government borrowing to finance a large and growing budget deficit has been much in the news recently.

The term ‘gilts’ derives from the bonds’ paper certificates historically having had a gilded edge. Arguably the first gilt issue was in 1694, when King William III borrowed in order to finance a war against France from the newly created Bank of England.

A gilt is characterised by three basic features called par value, time to maturity and coupon. Gilts will be redeemed sometime in the future (they mature) – the government buys back the security from the holder at its par value.

Gilts differ widely in their time to maturity. The coupon is the interest on the gilt, usually paid every six months. If I buy and hold a newly issued ten-year gilt with a par value of £100 and a coupon of 4%, I’ll receive a payment of £2 every six months for the next ten years, and then receive £100 on maturity.

If I don’t want to retain the bond until maturity, I can sell it: the price I receive is determined by the market at the time of sale. The yield on a gilt is the return received, including capital gains (or losses) as well as coupon payments.

There are many different interest rates in the economy – there is no such thing as ‘the’ interest rate. What interest rate an asset will pay will depend, inter alia, on its time to maturity and its perceived riskiness – for example how likely the issuer is to default. Gilts are usually considered safe assets as there is minimal risk of the government defaulting (but more on this below); however, they are risky in the sense that there is no guarantee of the price if one sells before maturity. Also a gilt may not protect the holder from inflation although there are some gilts (about a quarter of the UK’s outstanding stock of gilts) which are index linked and therefore offer some protection.

A crucial point about gilts is that there is an inverse relationship between prevailing interest rates and the market price of gilts, so that if interest rates in the economy rise, gilt prices will fall and vice versa.

Gilts in the UK are considered safe as there is confidence the government will not default. However, if a government loses credibility that it will repay its debt, then potential holders will require a higher return to compensate for the extra risk, so the government will need to offer a higher return on gilts. A vicious circle may ensue in which the deficit escalates, the government pays higher interest and the deficit worsens further. Hence the emphasis often put on the credibility of fiscal policy (taxation and government spending).

It might be argued that the government can always pay its debts as it can impose taxes or print money, something no individual or other organisation can do! But there may be constraints, political or practical, which may prevent the government from raising taxes sufficiently. Monetary policy, as in the UK since 1997, and as in many other countries, is often delegated to an independent central bank with an inflation mandate which may prevent the government from printing money to finance its debt. In theory the government could pass legislation removing the independence of the central bank, but this might well destroy the credibility of monetary policy leading to increased inflation.

There are hence very good reasons why fiscal policy needs to be credible. An illustration is the havoc in markets in the aftermath of the recent mini-budget, which brought into question the credibility of the government’s fiscal policy.