Question
Thanks so much for your helpful response to my previous question about investment in gilts. It helps me to understand so much more about gilts.
I still have a couple more questions to ask:
1. I went on UK Debit Management Office website, I found another type of gilts. Well, I am not sure if it is gilts.
For example: Treasury Coupon Strip 07Jun2016 and Treasury Principal Strip 07Sep2016. Are they gilts?
As you mentioned before, inflation and interest rate can influence the Conventional and Index-linked gilts.
But what about Gilt Strips? Those type of gilts seem do not pay any coupon. If the price of it now is 87 pounds, at redemption I will get 100 pounds back which means I get 100-87=13 pounds profit. Are these types of gilts safer compare to the other types of gilts in terms of inflation and interest fluctuation?
2. I am wondering if there is something called pledge loan in the UK or similar financial product. For instance, If I have an amount of investment in gilts, say 500,000, could I get some loans from the bank for helping me buy a property?
I really appreciate your help and time.Answer
You’re welcome. Gilts strips were introduced in 1997 and basically incorporate coupons (i.e. income) into the gilt’s maturity price rather than paying it out.
For example, suppose we have a gilt paying 4% over two years. Normally you’d invest 100p, receive income of 2p twice a year and get back the 100p at maturity. This could instead be split into five strips. The first strip would mature after 6 months and cost about 98p, so that the 100p you receive on maturity reflects the 2p coupon. The second strip pays out after 12 months and will likely cost less than 98p, as you’ll have to wait 12 months and not six to get the 2p coupon (i.e. the price is calculated using what called ‘discounted cash flow’) and so on. The final strip reflects the return of your 100p investment.
So what you’re effectively buying is a ‘zero coupon bond’, which is an investment that pays no income and has a certain value at a future date. The value the market places on these investments still depends on interest rate and inflationary expectations, just like conventional gilts. If interest rates are low then the opportunity cost of having your money tied up in a strip is low, so you wouldn’t expect a strip to trade at a big discount to its 100p maturity value. But if interest rates rise then having your money tied up in a strip becomes less attractive, so the price is likely to fall. Nevertheless, it will still revert to 100p on maturity. High inflation makes them less attractive as the 100p at maturity will be worth less in real terms.
Because there’s no opportunity to benefit from income meanwhile you’d expect strips to be more sensitive to interest rate and inflationary expectations/movements than conventional gilts, so they’re arguably more risky unless you plan to hold until redemption.
Because income is converted into a gain at maturity you might think strips are very tax efficient (gilts are exempt from capital gains tax), but sadly HMRC taxes these gains as income on an annual basis so there’s no loophole.
Five year strip yields are currently around 2.3% gross, very slightly higher than comparable conventional gilts.
While you might find a bank willing to lend you money secured against a gilt investment, the banks have become far more cautious post credit crunch, so you may have your work cut out. And if you can find one the interest rate charged is likely to be higher than the gilt yield (especially after tax), so might be counterproductive.
If you want a mortgage you could consider using an offset mortgage, which offsets your savings against the loan outstanding. This is very tax efficient as it effectively means you’re earning tax-free interest at the rate charged on the mortgage and very flexible as you can dip in and out of your savings as required.
Thanks so much for your helpful response to my previous question about investment in gilts. It helps me to understand so much more about gilts.
I still have a couple more questions to ask:
1. I went on UK Debit Management Office website, I found another type of gilts. Well, I am not sure if it is gilts.
For example: Treasury Coupon Strip 07Jun2016 and Treasury Principal Strip 07Sep2016. Are they gilts?
As you mentioned before, inflation and interest rate can influence the Conventional and Index-linked gilts.
But what about Gilt Strips? Those type of gilts seem do not pay any coupon. If the price of it now is 87 pounds, at redemption I will get 100 pounds back which means I get 100-87=13 pounds profit. Are these types of gilts safer compare to the other types of gilts in terms of inflation and interest fluctuation?
2. I am wondering if there is something called pledge loan in the UK or similar financial product. For instance, If I have an amount of investment in gilts, say 500,000, could I get some loans from the bank for helping me buy a property?
I really appreciate your help and time.Answer
You’re welcome. Gilts strips were introduced in 1997 and basically incorporate coupons (i.e. income) into the gilt’s maturity price rather than paying it out.
For example, suppose we have a gilt paying 4% over two years. Normally you’d invest 100p, receive income of 2p twice a year and get back the 100p at maturity. This could instead be split into five strips. The first strip would mature after 6 months and cost about 98p, so that the 100p you receive on maturity reflects the 2p coupon. The second strip pays out after 12 months and will likely cost less than 98p, as you’ll have to wait 12 months and not six to get the 2p coupon (i.e. the price is calculated using what called ‘discounted cash flow’) and so on. The final strip reflects the return of your 100p investment.
So what you’re effectively buying is a ‘zero coupon bond’, which is an investment that pays no income and has a certain value at a future date. The value the market places on these investments still depends on interest rate and inflationary expectations, just like conventional gilts. If interest rates are low then the opportunity cost of having your money tied up in a strip is low, so you wouldn’t expect a strip to trade at a big discount to its 100p maturity value. But if interest rates rise then having your money tied up in a strip becomes less attractive, so the price is likely to fall. Nevertheless, it will still revert to 100p on maturity. High inflation makes them less attractive as the 100p at maturity will be worth less in real terms.
Because there’s no opportunity to benefit from income meanwhile you’d expect strips to be more sensitive to interest rate and inflationary expectations/movements than conventional gilts, so they’re arguably more risky unless you plan to hold until redemption.
Because income is converted into a gain at maturity you might think strips are very tax efficient (gilts are exempt from capital gains tax), but sadly HMRC taxes these gains as income on an annual basis so there’s no loophole.
Five year strip yields are currently around 2.3% gross, very slightly higher than comparable conventional gilts.
While you might find a bank willing to lend you money secured against a gilt investment, the banks have become far more cautious post credit crunch, so you may have your work cut out. And if you can find one the interest rate charged is likely to be higher than the gilt yield (especially after tax), so might be counterproductive.
If you want a mortgage you could consider using an offset mortgage, which offsets your savings against the loan outstanding. This is very tax efficient as it effectively means you’re earning tax-free interest at the rate charged on the mortgage and very flexible as you can dip in and out of your savings as required.
Read this Q and A at http://www.candidmoney.com/questions/question237.aspx
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