Observations from the UK GILT Market

Have you ever wondered why the returns in the UK government bond market vary from one bond to another? In this article, we use our GILT Cloud application to help us understand these variations. We'll delve into how factors like coupon rates and maturity dates influence the returns in this market.

1. Short end vs long end risks

The returns on bonds with short maturities are primarily driven by the central bank's overnight lending rates. In contrast, long-term bond returns are influenced by additional factors, such as the risk of government default. Given the close relationship between risk and return, these additional risks usually lead to higher yields for long-dated bonds. For example, as of 9 September 2024, a 30-year bond is trading at a higher yield compared to a 5-year bond with a similar coupon :

Bond	Yield
4.125% Treasury Gilt 2029	3.77 %
4.375% Treasury Gilt 2054	4.44 %

This is the situation now, but it wasn't always like this. Not too long ago, we experienced an "inverted yield curve", where short-term yields exceeded long-term ones. The reasons for this have been highly debated in the financial media, with short-term inflationary pressures being the primary cause of the inversion.

1. The impact of tax rules

The total return from a bond investment consists of two elements: (a) interest payments and (b) capital gains. In the UK market, interest on government bonds is taxable, while capital gains are not. Consequently, investors looking to minimise their tax obligations may prefer lower-coupon bonds. The data below illustrates this behavior : whilst the bonds have a similar maturity, the one with a lower coupon has a lower yield. This is due to a price premium for its tax advantage.

Bond	Yield
4% Treasury Gilt 2060	4.38 %
0.5% Treasury Gilt 2061	4.08 %

1. Impact of duration and convexity

Just as speed measures the rate of change of distance over time, duration serves a similar function in the bond market. It indicates how sensitive a bond's price is to changes in interest rates. When these rates are falling, the price of a bond with higher duration rises faster than one with lower duration. In the current environment, where rates are expected to decline, investors may prefer holding bonds with longer durations.

This is only part of the story. Changes to variables can not always be accurately predicted from first order effects (such as speed and duration) alone. We may need to consider second and higher order factors to get more accurate answers. In the bond markets, the second order measures (convexity) are normally considered, but third and higher order ones are largely ignored. For the conventional gilts currently in issue, we can use our GILT Cloud application to understand how these measures vary from one bond to another: https://funclab.net/giltcloud

Note : we have ignored certain additional factors which may also come into play: (a) the variation in liquidity from one bond to another and (b) the implications of the futures market. Feel free to email me at [e-mail] if you want to share your thoughts or want to know about our products and services : https://funclab.net/