As interest rates have risen in recent months several of you have been asking us to explain the different yields that are quoted in respect of fixed income investments.

In the UK the most well-known, and the safest, type of fixed income investment is called a Gilt. A gilt or treasury bond is issued to raise funds on behalf of the government. The funds raised are guaranteed to be repaid, backed by the taxpayer, at a specified date in the future.

Since they are backed by taxation, Gilt-edged Securities are regarded as 100% risk-free. They are therefore fundamental to the finance industry.

How does this relate to yield?

When the government borrows money from you in return for a gilt, it specifies three conditions:

1) The rate of interest the government will pay, typically known as the “coupon.”

2) The term of the issue or the date when the gilt will be repaid.

3) The maturity value of the gilt. All conventional gilts (and most bonds in general) mature at 100. (There’s no mystery to that, it just makes % calculations easy).

Let’s assume that the government raises funds at the prevailing rate of interest; say 5% over a period of 5 years at an issue price of 100 per £100 nominal of stock.

If you buy the gilt at issue, you will receive £5 every year for five years and on the fifth anniversary you will receive your initial capital back; the original £100. In this case the income yield, 5%, is the same as the gross redemption yield, also 5%. “Gross” simply because the returns are achieved before they are taxed at whatever marginal rate you pay.

But most investors don’t invest in gilts at issue, they simply buy them in the secondary market when they need to. Gilts, like most bonds, are tradeable and their price in the market is set by the prevailing level of interest rates.

There is an iron rule of finance: “Yields move inversely to price”. If interest rates rise, gilt prices fall, if interest rates fall, gilt prices rise – but they all, in all circumstances, mature at 100.

In the example above, if interest rates drop to 3%, the price of the gilt will rise because investors will rush to lock-in a high yield before rates fall further. That might push the price of the gilt to 105 in the market.

So, what are your yields now?

The coupon remains the same, 5%. You will receive £5 every year until the gilt matures but remember that the gilt matures at £100 and you paid £105. Thus, you will lose £5 per £100 nominal on redemption. The redemption yield accounts for that loss on maturity taking the redemption yield below the coupon of 5%.

In summary:

Your coupon remains at 5%.

Your income yield is £5 divided by £105 (105 being the price of the gilt at purchase) which is 4.7%.

Your redemption yield is 3.89% which accounts for the £105 being repaid at £100.

Note that if you correctly anticipate a fall in interest rates from 5% to 3%, you enjoy a capital gain as the gilt price responds to the new, lower, level of interest rates. You can lock that gain in by selling the gilt prior to maturity.

There is a further quirk to this story. In the UK when you buy a gilt below par i.e. below £100, let’s say £90, the capital gain on maturity is tax free. Gilts are exempt from capital gains tax.

As interest rates have risen from zero to over 5% recently, many gilts are trading well below par offering higher rate taxpayers “gross equivalent yields” of up to 7.9% at current prices, and higher than rates currently available on cash deposits.

Not bad for a risk-free investment.