In the first of a series of extracts from his recently published book, Richard Leeson takes readers through some of the basics you need to know about investing. This week: gilts

What are gilts?

When a government’s tax receipts are not enough to cover its spending it needs to borrow money. If you are lending money to anyone, including the government, you will want to see something in writing that proves you have made the loan, what the interest rate is and when you will get your money back.

When you lend money to the UK government, the piece of paper that does this is called a “gilt”. (The term gilt is historic and comes from the days when they were described as “gilt-edged securities”, which in turn is because the piece of paper had a gold band on the edge.)

If you were lending money to a complete stranger you would want to see some form of security in case the person failed to pay you back. Whilst your borrower might have the best of intentions to repay you, being unexpectedly redundant, for example, can change priorities dramatically. This security (or collateral) is something of value that is usually worth at least as much as the loan so that, if you never see your money again, you can sell it and recoup your loss. Banks and building societies take your home as security when they give you a mortgage for this very reason.

When you lend money to the government though, it is slightly different. The government is not going to be made redundant and if it needs more money it can always raise taxes. In other words, your money is pretty safe if you lend it to the UK government; historically the UK government has never failed to repay its debt, both interest and capital. (That is not true of other governments around the world, though.) In short, lending money to the UK Government is about as guaranteed as you can get.

How gilts work

The people who raise money for the government are known as the Debt Management Office (DMO). Their website offers the following description: “Gilts are marketable sterling government bonds issued by the DMO on behalf of the UK Government as part of its debt management responsibilities.”

Conventional gilts

Conventional gilts are the simplest form of government bond and constitute the largest share of liabilities in the Government’s 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.

A conventional gilt is denoted by its coupon rate and maturity (e.g. 4% Treasury Gilt 2016). The coupon rate usually reflects the market interest rate at the time of the first issue of the gilt. Consequently there is a wide range of coupon rates available in the market at any one time, reflecting how rates of borrowing have fluctuated in the past. The coupon indicates the cash payment per £100 nominal that the holder will receive a year. This payment is made in two equal semi-annual payments on fixed dates six months apart (these payments are rolled forward to the next business day if they fall on a non-business day). For example, an investor who holds £1,000 nominal of 4% Treasury Gilt 2016 will receive two coupon payments of £20 each on 7 March and 7 September.

If you struggled to understand what that all means I think you’re probably in good company. So let me try and simplify it.

You have lent the government £1,000 until 2016 which they guarantee to pay back to you. Between now and then they will pay you 4% interest a year (known in the investment world as the “coupon”) on the £1,000 you have lent them. 4% of £100 is £4 and it is paid in two instalments each year, so you get £2 in May and £2 in September.

But there is a big difference between the interest rate on the gilt and interest rates on deposit and savings accounts.

Gilts are “fixed interest” investments, which means that the interest rate they pay does not change even if the Bank of England changes the base rate. Any changes in base rates will affect the rates offered on new issues of gilts, but it cannot change the interest rates on the ones that are already out there.

This is like fixed interest accounts at banks and building societies, but they are not “tradable”, because you cannot sell your bank account to someone else. You can, however, sell your gilt to someone else because it is “tradable”. You can buy and sell them and that makes gilts really interesting investments!

How and Why To Invest, Making Your Money Make You Money by Richard Leeson is available on Kindle for £4.03 at http://amzn.to/1dga4iS