Corporate bonds and gilts How gilts and corporate bonds work

How gilts and bonds work

Interest rates on gilts and corporate bonds change depending on the price you pay

A conventional UK gilt might look like this - "Treasury stock 3% 2020." 

This shows the following:

  • The department that is issuing the gilt - known as 'the issuer';
  • The rate of interest that will be paid - called the 'coupon';
  • And when the loan will be repaid - known as the 'redemption date'

If the UK government wanted to raise £100 million, it would issue one million gilts at the value of £100 each. This is known as the 'nominal value' or 'par'.

Similarly, a corporate bond might look this - "Tesco PLC 4% 2018" – the issuer, coupon and redemption date.

Returns from gilts and corporate bonds

If you buy £1,000 worth of Treasury stock 3% 2020 gilts, you would receive 3%, or £30, every year until your £1,000 loan is repaid in 2020. The income you receive is called the 'income yield', 'running yield' or 'interest yield' and is paid twice a year (1.5% or £15 every six months, in this instance).

The coupon is determined by the length of time you must wait for maturity and/or the riskiness of the company within which you invest. 

The further away the redemption date, the higher the interest you will receive as you are having to wait longer to be repaid. Similarly, the greater the risk you take on a company, the higher the interest rate you can expect to receive.

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Gilts and corporate bonds on the secondary market

You can buy gilts at issue from the government's Debt Management Office, but most gilts, government bonds and corporate bonds are traded on a secondary market and their value can fluctuate, based upon interest rates and the solvency of the issuer. 

Bond prices will rise when general interest rates are low, because the rates of interest they pay are fixed and will beat the short-term rates available from banks.

Therefore, you may buy a bond or gilt for an amount above or below the nominal value and this will have an impact on both how much interest you receive as an income and the amount of money you will receive when the bond matures. 

It works like this: 

  • If, for example, you paid £95 for a gilt, government bond or corporate bond with a nominal value £100, you will make a capital gain when it matures, as the loan is repaid at the nominal value.
  • Similarly, if you bought the gilt, government bond or corporate bond for £105, you would lose out on maturity, as you're only paid back at the nominal value.
  • The amount of interest you'll receive will also change dependent on the price you paid. If you buy a bond or gilt paying 6% for, say, £95, the effective interest rate you'll receive is higher than 6% as interest is paid on the nominal value, not the second-hand market price you paid.
  • In this example, the rate you receive is actually 6.32% (i.e. 6%/£95 = 6.32%).

What is the 'redemption yield' of a gilt or corporate bond?

The redemption yield is a rate of return that combines the interest rate you get based on the price at which you buy the gilt, government bond or corporate bond, and the profit or loss you get if you hold the bond to maturity.

If you bought a gilt, government bond or corporate bond at a price that's lower than the launch price (£100), the redemption yield will be higher than the running yield, as you're set to make a profit when the bond matures. 

Conversely, if you bought a gilt, government bond or corporate bond at a price that's higher than the launch price (£100), the redemption yield will be lower than the running yield, as you'll make a loss if you hold the bond to maturity.

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Last updated:

July 2016

Updated by:

Michael Trudeau

 

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