1.3 Government Debt Flashcards
What the three classes of Government Debt?
Government debt, such as UK gilts, can be divided into three classes:
• Short-, medium- and long-dated;
• Dual-dated;
• Undated.
UK gilts include Treasury stocks and Exchequer stocks.
Government Debt
Most developed countries have active markets for bonds issued by their government, eg, ‘gilts’ are bonds issued by the UK government. They are issued to cover the government’s borrowing needs, and the UK Treasury has created an executive agency called the Debt Management Office (DMO) to issue, service and manage gilts on its behalf.
As with other bonds, gilts are issued with a given nominal value that will be repaid at the bond’s redemption date, and a coupon rate representing the percentage of the nominal value that will be paid to the holder of the bond each year. Obviously different gilts can have different redemption dates, and the coupon is payable at different points of the year (generally at semi-annual intervals).
Short-, Medium- and Long-Dated Gilts
These are the simplest form of UK government bonds and constitute the largest proportion of the gilts in issue. They are fixed coupon gilts with fixed redemption dates and are subdivided by the DMO into three, based on the period of time that remains until the gilt matures:
• Short – less than seven years to redemption;
• Medium – between seven and 15 years to redemption;
• Long – over 15 years to redemption.
For example, 4.25% Treasury Gilt 2039 would be classified as a long-dated gilt because more than 15 years remain until it reaches its redemption date of 7 September 2039.
Inflation
Inflation can be one of the most significant obstacles to successful investing because the real value of the income flow from investments such as bonds and equities, as well as the long-term value of capital, is eroded by the effects of inflation and the decline in the purchasing power of the wealth that is created.
Controlling inflation is the prime focus of economic policy in most countries, as the economic costs inflation imposes on society are far-reaching. While there are many negative consequences, the two which are most pertinent for the typical investor are that:
• inflation reduces the spending power of those dependent on fixed incomes, ie, pensions or fixed coupon investments such as a typical corporate bond (inflation-linked bonds are discussed in Section 3.3.3);
• individuals are not rewarded for saving. This occurs when the inflation rate exceeds the nominal interest rate; that is, the real interest rate is negative.
Real interest rates are calculated as follows:
Real interest rate = [(1 + nominal interest rate) / (1 + inflation rate)] – 1
So, the real return takes into account the inflation rate and in times of excessive inflation the real returns available may well become negative.
In addition to the specific impact of inflation on returns mentioned, the broader macro-economic problems associated with periods of high inflation are well illustrated by the difficulties faced by investors during the 1970s. This was a period of extremely high inflation, fuelled by surging commodity prices, especially crude oil, which led to demands from organised labour for higher wages. This pushed up the costs to producers of goods and services who, in turn, pushed on these additional costs to end- consumers in the form of higher prices. A vicious circle was created which required very drastic increases in short-term interest rates at the end of the 1970s – the base rates in the US and UK were approximately 20% as the 1980s began – and this caused widespread distress for asset prices. The 1970s was one of the worst periods on record for global stock market returns.
Inflation will also have negative implications for holders of bonds and fixed-income instruments. A major driver of bond prices is the prevailing interest rate and expectations of interest rates to come. Yields required by bond investors are a reflection of their interest rate expectations, which, in turn, will be largely influenced by expectations about inflation. For example, if inflation and interest rates are expected to rise, bond prices will fall to bring the yields up to appropriate levels to reflect the interest rate increases. To remain competitive, equities prices would also suffer.
Retail Prices Index
Index-linked bonds are ones where the coupon and the redemption amount are increased by the amount of inflation over the life of the bond. The amount of inflation uplift is determined by changes in the retail prices index (RPI).
The RPI, historically, has been the main inflation index used in the UK. It is calculated by looking at the prices of a basket of over 300 goods. The prices are then weighted to reflect the average household’s consumption patterns, so those important items on which a lot of money is spent receive a higher weighting than peripheral items.
The index itself is based on movements in prices since a base period. The markets concentrate on the RPI figure, as it is a good indicator of the level of inflation and, consequently, government reaction to it. It also signals the need for potential increases in the yield paid on bonds in order to compensate for the erosion of real returns.
Two more refined measures introduced in the 1990s were the RPIX, which excludes the impact of mortgages, and the RPIY, which excludes mortgages and indirect VAT and local authority taxes.
Consumer Prices Index
Historically, the RPIX was used by the government in specifying its inflation target at a level of 2.5%. In December 2003, the Chancellor of the Exchequer changed the UK inflation target to a new base, the harmonised index of consumer prices (HICP), which was renamed the consumer prices index (CPI).
The level of the new CPI inflation target for the BoE’s MPC was set at 2% from 10 December 2003. Note that index-linked gilts continue to be calculated on exactly the same basis as in the past, with reference to the RPI, while pensions and benefits were linked to the CPI as of April 2011.
The CPI is calculated each month by taking a sample of goods and services that a typical household might buy, including food, heating, household goods and travel costs.
HICPs were originally developed in the European Union (EU) to assess whether prospective members of European Monetary Union (EMU) would pass the required inflation convergence criterion, and then to act as the measure of inflation used by the European Central Bank (ECB) to assess price stability in the euro area.
Producer prices indices (PPIs)
Producer prices indices (PPIs) measure inflationary pressures at an earlier stage in the production process. Input prices measure the change in prices going into the production process. This will include raw materials and other inputs. Changes in commodity prices will directly affect this number. Output or factory gate prices measure the changes in the price on goods as they leave the production process and enter the retail sector. There is obviously a very strong relationship with input price variation.
Historically, any changes in raw material prices have tended to pass on through the productive process and resulted in higher retail prices. In recent years, the generally low level of inflation, coupled with the more competitive nature of the labour market, has made it increasingly difficult for producers to pass on price increases. Consumers are now used to stable prices and are unable to force their wages up in order to compensate for the higher prices.
Summary of Inflation Measures
The main measures of inflation used in the UK are:
• CPI – based on an EU-wide formula allowing direct comparison of the inflation rate in the UK against that in the rest of Europe.
• RPI – an average measure of change in the prices of goods and services. Once published, it is never revised.
• RPIX – RPI excluding mortgage costs. It was previously the target measure for the MPC with a target of 2.5%
• RPIY – this is RPI with both mortgage costs and the impact of changes in taxation removed.
• PPI – this is based on measuring inflation further up the supply chain at the wholesale level and is sometimes known as ‘factory gate’ inflation.
A key advantage of the RPI and RPIX is their familiarity and credibility based on their longer history. It will be some time before the CPI becomes as widely recognised. The CPI’s exclusion of most elements of owner-occupier housing costs lessens its relevance for some users, but this must be weighed against the significant difficulties encountered in measuring such costs appropriately, reflected in the absence of any international consensus in this area.
Index-Linked Bond
Index-linked bonds (such as index-linked gilts) differ from conventional bonds in that the coupon payments and the principal are adjusted in line with a published index of price inflation, such as the RPI. This means that both the coupons and the principal on redemption paid by these bonds are adjusted to take account of inflation since the bond’s issue. Assuming inflation is positive, the nominal amount outstanding of an index-linked bond is less than the redemption value the government will pay on maturity.
To calculate the inflation adjustment for a coupon payment, two index figures are required: that applicable to the bond when it was originally issued, and that relating to the point at which interest is paid. For UK gilts, the RPI figures used were originally those applicable eight months before the relevant dates (eg, for a December coupon, the previous April RPI data is used). This indexation lag was shortened for index- linked gilts issued after 2005 to just three months and it is the method for index-linking these gilts that is explained below.
Index Ratio
An index ratio is used to calculate the coupon payments and the redemption payment. The index ratio for each index-linked gilt measures the growth in the RPI since the gilt was first issued. For a given date, it is the ratio of the reference RPI applicable to that date divided by the reference RPI applicable to the original issue date of the gilt.
The reference RPI for the first calendar day of any month is the RPI for the month three months earlier (so the reference RPI for 1 June is the RPI for March, for the 1 July it is the RPI for April, etc). The reference RPI for any other day in the month is calculated by linear interpolation between the reference RPI applicable to the first calendar day of the month in which the day falls and the reference RPI applicable to the first calendar day of the month immediately following.
The nominal amount of the index-linked gilt is uplifted by the index ratio to give an updated principal. This principal is then used to generate the coupon payable by multiplying by the coupon payable. The coupon payments on an index-linked gilt that pays coupons half-yearly are based on the stated coupon divided by two and multiplied by the nominal value uplifted by the relevant index ratio. The redemption payment is based on the nominal value uplifted by the index ratio that applies at the point of redemption, namely the RPI three months prior to redemption divided by the RPI three months prior to the gilt’s issue date.
Zero Inflation
Because these bonds are uplifted by increases in the relevant price index, they are effectively inflation- proof. In times of inflation, they will increase in price and preserve the purchasing power of the investment.
In a period of zero inflation, index-linked bonds will pay the nominal coupon rate with no uplift and simply pay back the nominal value at maturity. If there has been deflation rather than inflation over the period between issue and a coupon payment or redemption, index-linked gilts have no deflation floor, so the investor could receive less than the nominal coupon and less than the nominal value at maturity.
