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Trading and Capital-Markets Activities Manual

Instrument Profiles: United Kingdom Government Bonds
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

United Kingdom government bonds, known as ''gilts'' or ''gilt-edged stocks,'' are Sterling-denominated bonds issued by the Bank of England (BOE) on behalf of the Treasury. The bonds are unconditionally guaranteed by the U.K. government and, therefore, are considered to have very low credit risk. Shorts are those gilts having 0 to 5 years remaining to maturity; mediums, 5 to 15 years; and longs, over 15 years. The securities are generally held in registered form in the domestic settlement system. The securities can also be held via Euroclear and Cedel. 

CHARACTERISTICS AND FEATURES 

Gilts come in a variety of structures. Conventional gilts or ''straights'' are non-callable bullet issues that pay interest semi-annually. These bonds comprise around 80 percent of the outstanding gilt-edged securities. The government also issues callable gilts, so called ''double-dated'' gilts, which may be called at the government's discretion anytime after the designated call date. In addition to these bonds, a number of non-conventional gilt issues are considered to be of minor importance because of their insignificant issue sizes and lack of liquidity. Such non-conventional issues include convertible gilts (in which short-dated bonds may be converted to longer-dated bonds), index-linked gilts, and irredeemable gilts (consols). Most gilt issues pay a fixed coupon. Floating-rate gilts, first issued in March 1994, have coupon payments linked to the London Interbank Bid Rate (LIBID). Unlike fixed-rate gilts, interest on floating-rate gilts is paid quarterly to investors. 

Settlement in the gilt market is usually done on the market date following the trade date (T+1), although two-day and seven-day settlements are also fairly common. Deals are normally cleared through the Bank of England's Central Gilt Office (CGO). The CGO is linked to Euroclear and Cedel. Interest is calculated using an actual/365-day count. 

USES 

Gilts are used for investment, hedging, and speculative purposes by domestic and foreign entities. While foreign investors may buy gilts as a means of diversifying their investment portfolios, gilts may also be used to hedge positions that are sensitive to movements in U.K. interest rates or foreign-exchange rates. Speculators, on the other hand, may use longterm bonds to take positions on changes in the level and term structure of interest rates. 

DESCRIPTION OF MARKETPLACE 

Issuing Practices 

The BOE issues a debt management report in March of each year, which lays out gilt-issuance plans for the fiscal year running from April to March. The report represents the Treasury's forecast of the gilts that need to be sold and also details the percentage of issuance expected to fall into each area of the maturity spectrum. Complete details of the auction, including the amount and terms of gilt to be auctioned and other information, are announced eight days before the auction. Gilt-edged market makers (GEMMs) quote prices on a when-issued basis. Deals cannot be settled until the business day after the auction when trading in the newly issued bonds officially begins. The existence of a shadow market, however, ensures that the market can trade to a level where new bonds will be easily absorbed, limiting the chances of a surplus inventory of bonds. 

During the auction process, bids are accepted on a competitive and a non-competitive basis. Competitive bids are for a minimum of 500,000 and can be made at any price. Bids are accepted going from the highest price to the lowest price until the bank exhausts the amount of securities it wants to sell. If the issue size is not large enough to satisfy demand at the lowest accepted price, bidders get a proportion of their requests. In such a bid, the BOE cannot give more than 25 percent of the amount offered to any one bidder. Non-competitive bids vary between 1,000 and 500,000 per bidder. Bonds are allocated to non-competitive bidders at a price equal to that of the weighted average of bids filled in the competitive auction. 

The BOE also sells a fixed amount of securities at a fixed price (tap form). This form of issuance allows the BOE to respond to market demand and add liquidity to the market. More specifically, tap issues are normally done from the supply of bonds that have not been sold at an auction. Typically, bonds are held back with the intent to sell them when demand has improved or when there is an increased need for funds. In a tap issuance, stock is issued to GEMMs in the form of ''tranchettes,'' typically up to 500 million. 

Payment for gilts may be made in full or in part. In a partly paid auction, competitive bidders are required to deposit a portion of the amount bid, with the rest due after issue as specified in the prospectus. In a partly paid auction, the first coupon payment and the market price reflect the partly paid status of the gilt. After the installments are cleared as per the prospectus, the partly paid distinction disappears. 

Secondary Market 

U.K. gilts are traded on the London Stock Exchange, International Stock Exchange, and London International Financial Futures Exchange (LIFFE). Gilts can be traded 24 hours a day. Generally, gilts are traded on the International Stock Exchange between the hours of 9 a.m. and 5 p.m. and on the LIFFE between the hours of 8:30 a.m. and 4:15 p.m. and between 4:30 p.m. and 6:00 p.m. The typical transaction size in the secondary market varies between 5 to 100 million. 

Market Participants 

Sell Side 

The primary dealers of U.K. government bonds are known as gilt-edged market makers or GEMMs. GEMMs quote the exact size, amount, and terms of the issuance beginning eight days before an auction, thereby creating a ''shadow market.'' At this time, they quote prices on a when-issued basis. 

Buy Side 

A wide range of investors use U.K. government bonds for investing, hedging and speculation. This includes banks, non-financial corporate and quasi-corporate public and private enterprises, pension funds, charities, pension arms of life insurance companies, and private investors. The largest holders of gilts are domestic entities, but foreign investors, including U.S. banks, are also active participants in the market. 

Market Transparency 

The gilt market is active and price transparency is relatively high for these securities. Several information vendors disseminate prices to the investing public, including Reuters. 

PRICING 

Prices are quoted as a percent of par in 32nds. For example, a price of 98:16 means that the price of the bond is 98.5 percent of par value (98 16/32). Prices are quoted on a clean-price basis, net of accrued interest. The settlement price takes accrued interest into account so that the total price equals the clean price plus or minus the accrued interest. The bid/offer spreads tend to be extremely thin. For liquid issues with a maturity of up to seven years, the spread is normally 1/16 or less; for liquid issues with longer maturities, the spread is normally 1/16 to 1/8. 

HEDGING 

U.K. gilts may be hedged for foreign-exchange risk using foreign-exchange options, forwards, and futures. These securities can be hedged for interest-rate risk by taking a contra position in another gilt or by using derivative instruments such as forwards, swaps, futures, or options. Currently, the LIFFE gilt futures contract is the most heavily traded hedging instrument. The effectiveness of a particular hedge depends on the yield curve and basis risk. For example, hedging a position in a six-year note with an over-hedged position in a two-year bill may expose the dealer to yield curve risk. Hedging a 30-year bond with a bond future exposes the dealer to basis risk if the historical price relationships between futures and cash markets are not stable. 

RISKS 

Liquidity Risk 

Gilts trade in an active and liquid market. Liquidity in the market is ensured by the BOE, which is responsible for maintaining the liquidity and efficiency of the market and, in turn, supervises the primary dealers of gilts. GEMMs, who act as primary dealers, are required to quote two-way prices at all times. An increase in foreign investment activity in the gilt market has led to a substantial increase in competition and enhanced liquidity. 

Liquidity is also enhanced through the BOE's ability to reopen auctions and tap issues. The ability to reopen issues improves liquidity and avoids the unfavorable pricing that may occur when the market is flooded with one very large issue. A tap issue, as explained above, allows the BOE to relieve market shortage of a particular bond. An active repo market allows market makers (GEMMs) to fund their short positions, and it improves turnover in the cash market, attracting international players familiar with the instrument, which further improves liquidity. 

Foreign-Exchange Risk 

Currency movements have the potential to affect returns of fixed-income investments whose interest and principal are paid in foreign currencies. The devaluation of a foreign currency relative to the U.S. dollar would not only affect a bond's yield, but would affect bond pay-offs in U.S. dollar terms. Some factors that may affect the U.K. foreign-exchange rate include- 

  wider exchange-rate mechanism bands, which increase the risk of holding high-yielding currencies; 
  central bank intervention in the currency markets; 
  speculation about the European economic and monetary union and its potential membership, which puts European currencies under pressure vis-a`-vis the deutsche mark; and 
  endemic inflation in the United Kingdom. 

Political Risk 

A change in the political environment, withholding tax laws, or market regulation can have an adverse impact on the value and liquidity of an investment in foreign bonds. Investors should be familiar with the local laws and regulations governing foreign bond issuance, trading, transactions, and authorized counterparties. 

ACCOUNTING TREATMENT 

The Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,'' determines the accounting treatment for investments in foreign debt. SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

United Kingdom government bonds are assigned to the 0 percent risk-weight category. 

LEGAL LIMITATIONS FOR BANK INVESTMENT 

United Kingdom government bonds are type III securities. As such, a bank's investment in them is limited to 10 percent of its equity capital and reserves. 

REFERENCES 

 Euromoney. The 1996 Research Guide to London. December 1995. 
 Euromoney. Central Banks, How Central Banks Play the Market. September 1992. 
 Fabozzi, Frank J. Bond Markets, Analysis, and Strategies. 3d ed. Upper Saddle River, N.J.: Prentice-Hall, 1996. 
 Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The Handbook of Fixed Income Securities. 4th ed. New York: Irwin, 1995. 
 J.P. Morgan Securities. Government Bond Outlines. 9th ed. April 1996. 
 Roche, David. Against the Tide: Europe's Submerging Bond Markets. October 1994. 
 Urich, Thomas J. U.K., German and Japanese Government Bond Markets. Monograph Series in Finance and Economics. New York: New York University Salomon Center at the Leonard N. Stern School of Business, 1990. 
 Walker, Rupert G. Can Gilts Get Glitzier? December 1995. 

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