Conventional gilts

UK index-linked gilts have existed since March 1981, with the FT All Index-Linked coming into existence at the end of that year. Unsurprisingly, index-linked have underperformed conventional gilts over their full history, given the collapse in inflation and inflationary expectations since the market s inception. In March 1981, the launch month of the first linker (2% IL 1996), headline UK inflation was 12.6%. We have seen inflation fall by 10%. (See Exhibit 8.12.)... 

Exhibit 8.13 shows a scatterplot of average annual real returns against risk (the volatility of those real returns) since end-1981, for linkers, conventional gilts, equities, and gold. Gold has historically been regarded as the nltimate real asset. 

EXHIBIT 8.12 Nominal Total Return Indices for UK Equities, Conventional Gilts and Index-Linked Gilts, End-1981 = 100... 

The gilts market is primarily a plain vanilla market, and the majority of gilt issues are conventional fixed interest bonds. Conventional gilts have a fixed coupon and maturity date. By volume they made up 82% of the market in June 2002. Coupon is paid on a semi-annual basis. The coupon rate is set in line with market interest rates at the time of issue, so the range of coupons in existence reflects the fluctuations in market interest rates. Unlike many government and corporate bond markets, gilts can be traded in the smallest unit of currency and sometimes nominal amounts change hands in amounts quoted down to one penny ( 0.01) nominal size. 

Gilt strips are zero-coupon bonds created from conventional coupon gilts. Only issues actually designated as strippable gilts may be stripped. They trade as conventional zero-coupon bonds and are deemed as conventional gilts in terms of their creditworthiness. 

Auctions are the primary means of issuance of all gilts, both conventional and index-linked. They are generally for 2- 3 billion of stock on a competitive bid price basis. Auctions of index-linked gilts are for between 0.5 and 1.25 billion. The programme of auctions is occasionally supplemented in between auctions by sales of stock on tap. This is an issue of a further tranche of stock of a current issue, usually in conditions of temporary excess demand in that stock or that part of the yield curve. That said, only one conventional stock has been tapped since 1996, a 400 milHon conventional tap in August 1999. The DMO has stated that tap issues of conventional gilts will only take place in exceptional circumstances. 

Auction bids for I-L gilts are also competitive and noncompetitive. Only IG GEMMs may make competitive bids, for a minimum of 1 million nominal and in multiples of 1 million. For I-L gilts there is a uniform price format, which means that all successful bidders receive stock at the same price. A bid above the successful price will be allotted in full. Noncompetitive bids must be for a minimum of 100,000, and will be allotted in full at the successful bid price (also known as the strike price). IG GEMMs are reserved up to 10% of the issue in the noncompetitive bid facility. Non-IG GEMMs must complete and submit an application form in the same way as for conventional gilt auctions. 

One final point regarding duration is that it is possible to calculate a tax-adjusted duration for an index-linked bond in markets where there is a different tax treatment to indexed bonds compared to conventional bonds. In the United States market, the returns on indexed and conventional bonds are taxed in essentially the same manner, so that in similar fashion to Treasury strips, the inflation adjustment to the indexed bond s principal is taxable as it occurs, and not only on the maturity date. Therefore, in the US-indexed bonds do not offer protection against any impact of after-tax effects of high inflation. That is, Tips real yields reflect a premium for only pretax inflation risk. In the United Kingdom market however, index-linked gilts receive preferential tax treatment, so their yields... 

Using the prices of index-linked bonds, it is possible to estimate a term structure of real interest rates. The estimation of such a curve provides a real interest counterpart to the nominal term structure that was discussed in the previous chapters. More important it enables us to derive a real forward rate curve. This enables the real yield curve to be used as a somce of information on the market s view of expected future inflation. In the United Kingdom market, there are two factors that present problems for the estimation of the real term structure the first is the 8-month lag between the indexation uplift and the cash flow date, and the second is the fact that there are fewer index-linked bonds in issue, compared to the number of conventional bonds. The indexation lag means that in the absence of a measure of expected inflation, real bond yields are dependent to some extent on the assumed rate of future inflatiOTi. The second factor presents practical problems in curve estimation in December 1999 there were only 11 index-linked gilts in existence, and this is not sufficient for most models. Neither of these factors presents an insurmountable problem however, and it is stiU possible to estimate a real term structure. 

The date used as the point for calculation is the settlement date for the bond, the date on which a bond will change hands after it is traded. For a new issue of bonds the settlement date is the day when the bond stock is delivered to investors and payment is received by the bond issuer. The settlement date for a bond traded in the secondary market is the day that the buyer transfers payment to the seller of the bond and when the seller transfers the bond to the buyer. Different markets will have different settlement conventions for example, UK gilts normally settle one business day after the trade date (the notation used in bond markets is T+ 1) whereas Eurobonds settle on T + 3. The term value date is sometimes used in place of settlement date, however the two terms are not strictly synonymous. A settlement date can only fall on a business date, so that a gilt traded on a Friday will settle on a Monday. However a value date can sometimes fall on a nonbusiness day. 

Double-dated issues are usually less liquid than conventional or index-linked gilts (I-L gilts), mainly becanse there is a relatively small amount in issue and also becanse a larger proportion are held by personal investors. They also tend to have high conpons, reflecting the market rates in existence at the time they were issned. 

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