The interest rate is based on the face value (the issue value) of each stock and is usually set at the market rate when the stock is issued. The percentage rate on the face value is called the coupon.

Interest is fixed for each stock, or in some cases is index linked, i.e. expressed as a fixed percentage above the retail price index.

Redemption is usually set between two dates a few years apart, leaving the government some choice. The face value is repaid on redemption, indexed in the case of index linked stocks. There are a few old issues which are irredeemable; they are called undated stocks.

Market price

This fluctuates in accordance with the relationship between current interest rates and the set rate on the stock. However, the length of time to redemption also influences the market price, bringing it nearer the face value as the redemption date approaches.

Another important factor affecting the price movement of gilts is that short term interest rates tend to be more volatile than longer term rates.

The price also takes into account the timing of interest payments on a stock. The price includes interest from the last payment date until the trading date (cum interest) but frorn a specified date the seller keeps the next interest payment and the price falls accordingly. (The stock is then described as ex interest.)

When interest rates are low, stocks which carry a higher rate of interest on the issue value will be priced above that value and so (other things being equal) the price will fall over the period to redemption.

Yield

The yield (interest as a percentage of current market price) is expressed in two ways interest only and redemption, the latter also taking into account the difference between the current price and the redemption value, allowing for the time to redemption.

Interest payment

interest is paid half yearly and is taxable (capital gains are not taxable). It is paid gross i.e. before tax, although you can elect for it to be paid net of tax, except in the case of stock bought through the Bank of England.

Buying and selling gilts

Gilts are traded on the Stock Exchange and form by far the largest value of dealings there. They are grouped into various categories:

• redemption less than five years away (shorts);
• redemption between five and ten years away;
• redemption between ten and 15 years away;
• redemption over 15 years away;
• undated (no redemption date); and
• index linked.

There is another way for small investors to buy and sell through the Bank of England Brokerage Service. Most stocks are included in it, but not all.

Purchases and sales are made by completing and posting a form, which can be obtained at any post office, together with an explanatory leaflet which lists the available stocks. The cost of dealing is lower than through a stockbroker. Dealing is slower this way and you cannot set limits, so it is slightly more risky, but prices would only change significantly if there were to be a change (or expected change) in interest rates.

New gilt issues are made by auction, which has the advantage that there is no commission or spread (the difference between buying and selling prices). Fifty per cent of the value must be put up in advance.

The competitive auction is not suitable for individuals but you can bid on a non competitive basis, by which you will receive the stock you have bid for (possibly scaled down if the bids exceed the issue amount) at the average price bid by the experts.

Choosing a gilt

Your tax position is important. Higher rate taxpayers should consider gilts with an interest rate lower than the current market rate because some of the redemption yield is capital growth which is not taxable.

Non taxpayers should go for those with a high coupon rate with a price above par because of the relatively high interest yield.

Basic rate taxpayers are usually recommended to avoid gilts with a current market price above par because the capital loss to maturity will probably not be fully offset by the taxed income.

Gilt strips

Only recently introduced, strips divide a gilt into separate parts, one for each interest payment (a coupon strip) and one for the repayment value (a principal strip).

The attraction is the certainty regarding repayment because the principal strip is bought at a discount and the subsequent gain is guaranteed. The disadvantage is that the capital gain is treated as income in the year it is sold or redeemed.

Principal strips can be useful when investing for a specific purpose, particularly if protected from income tax in an ISA.

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