UK GILTS: ANALYSIS OF BOND INVESTMENTS Professor Nuno Fernandes prepared this case as a basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation. Petr Cech, a financial analyst at MU Securities, was in charge of fixed income strategies trading. In particular, he was responsible for his company's investments in UK government bonds, commonly known as gilts. Cech was now responsible for valuing a series of bonds, with maturities ranging from 1 to 50 years. These bonds varied in the coupon rate paid, as well as their price. Indeed, since the issuance data, many of these bonds had significantly changed their prices. The goal was to identify the appropriate price and yield-to-maturity for each bond (refer to Exhibit 1 for some of the known parameters on the bonds), as well as to compute their sensitivity to interest rate risk. UK Gilts A gilt is a UK Government liability in sterling, issued by HM Treasury and listed on the London Stock Exchange. The term "gilt" is a reference to the primary characteristic of gilts as an investment: their security. This is a reflection of the fact that the British Government has never failed to make interest or principal payments on gilts as they fall due. The gilt market is essentially comprised of two different types of securities - conventional gilts and index-linked 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. 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 per year. This payment is made in two equal semi-annual payments on fixed dates six months apart. 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. Conventional gilts also have a specific maturity date. In the case of 4% Treasury Gilt 2016 the principal will be repaid to investors on 7 September 2016. In recent years the Government has concentrated issuance of conventional gilts around the 5., 10- and 30-year maturity areas. In May 2005, however, the Government issued a new 50-year maturity conventional gilt, but the liquidity in the secondary market is low. Index-linked gilts, differ from conventional gilts in that the semi-annual coupon payments and the principal are adjusted in line with the UK Retail Prices Index (RPI). This means that both the coupons and the principal paid on redemption of these gilts are adjusted to take account of accrued inflation since the gilt was first issued. However, as index-linked coupons reflect the real borrowing rate for the Government rather than the nominal borrowing rate, there is a much smaller variation in real yields over time. Exhibit 1 UK Gilts Price YTM Coupon Maturity 102.50 374% 1 year 1.74 54% 2 years 107.02 4% 3 years 3.00 274% 5 years 108.91 5% 7 years 4.04 39% 10 years 104.93 474% 20 years 4.36 472% 30 years 94.96 4% 50 years Case 2 - UK Gilts: Analysis of Bond Investments 1. (1 pt) What is the difference between the coupon rate and yield to maturity, and how does the difference affect the bond prices? 2. (1 pt) Using the data in Exhibit 1, calculate the YTM for the following UK Gilts: 1 year 3 years 7 years 20 years 50 years 3. (1 pt) Using the data in Exhibit 1, value the following UK Gilts: 2 years 5 years 10 years 30 years 4. (2 pts) Plot the yield curve that results from the given bonds. 5. (1 pt) What happens to the bond prices if all of the yields move up by 1%? 6. (1 pt) What are the risks (if any) of investing in UK Gilts? UK GILTS: ANALYSIS OF BOND INVESTMENTS Professor Nuno Fernandes prepared this case as a basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation. Petr Cech, a financial analyst at MU Securities, was in charge of fixed income strategies trading. In particular, he was responsible for his company's investments in UK government bonds, commonly known as gilts. Cech was now responsible for valuing a series of bonds, with maturities ranging from 1 to 50 years. These bonds varied in the coupon rate paid, as well as their price. Indeed, since the issuance data, many of these bonds had significantly changed their prices. The goal was to identify the appropriate price and yield-to-maturity for each bond (refer to Exhibit 1 for some of the known parameters on the bonds), as well as to compute their sensitivity to interest rate risk. UK Gilts A gilt is a UK Government liability in sterling, issued by HM Treasury and listed on the London Stock Exchange. The term "gilt" is a reference to the primary characteristic of gilts as an investment: their security. This is a reflection of the fact that the British Government has never failed to make interest or principal payments on gilts as they fall due. The gilt market is essentially comprised of two different types of securities - conventional gilts and index-linked 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. 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 per year. This payment is made in two equal semi-annual payments on fixed dates six months apart. 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. Conventional gilts also have a specific maturity date. In the case of 4% Treasury Gilt 2016 the principal will be repaid to investors on 7 September 2016. In recent years the Government has concentrated issuance of conventional gilts around the 5., 10- and 30-year maturity areas. In May 2005, however, the Government issued a new 50-year maturity conventional gilt, but the liquidity in the secondary market is low. Index-linked gilts, differ from conventional gilts in that the semi-annual coupon payments and the principal are adjusted in line with the UK Retail Prices Index (RPI). This means that both the coupons and the principal paid on redemption of these gilts are adjusted to take account of accrued inflation since the gilt was first issued. However, as index-linked coupons reflect the real borrowing rate for the Government rather than the nominal borrowing rate, there is a much smaller variation in real yields over time. Exhibit 1 UK Gilts Price YTM Coupon Maturity 102.50 374% 1 year 1.74 54% 2 years 107.02 4% 3 years 3.00 274% 5 years 108.91 5% 7 years 4.04 39% 10 years 104.93 474% 20 years 4.36 472% 30 years 94.96 4% 50 years Case 2 - UK Gilts: Analysis of Bond Investments 1. (1 pt) What is the difference between the coupon rate and yield to maturity, and how does the difference affect the bond prices? 2. (1 pt) Using the data in Exhibit 1, calculate the YTM for the following UK Gilts: 1 year 3 years 7 years 20 years 50 years 3. (1 pt) Using the data in Exhibit 1, value the following UK Gilts: 2 years 5 years 10 years 30 years 4. (2 pts) Plot the yield curve that results from the given bonds. 5. (1 pt) What happens to the bond prices if all of the yields move up by 1%? 6. (1 pt) What are the risks (if any) of investing in UK Gilts