Gilts have an edge if inflation stays low

Investors who want to maximise income without exposing their money to high risk are often advised to buy gilts.

Gilts are IOUs issued by the government to finance its borrowing requirement. In return for the investor's money, the government normally promises to pay a set amount of interest each year and to return the money on a pre- determined date. As the government is highly unlikely to renege on its debts, gilts are regarded as rock solid investments.

It is this safety, combined with a guaranteed, if taxable, income (currently up to 9 per cent), that has made gilts popular, particularly among investors for whom income, rather than capital growth, is important.

However, it is just as possible to lose money on gilts as it is by investing in shares. Gilts are issued with a par value, the value that is paid to the holder on maturity when the government redeems that part of its debt. An investor who holds the gilt to maturity knows exactly what value he will receive. But during its life, the gilt's value will fluctuate according to several economic factors, the most important of which is interest rates. As interest rates fall, demand for the income paid by a gilt is likely to rise, and the price will increase accordingly. Likewise, when interest rates rise, the price of gilts is likely to fall.

Historically, gilts have been poor investments in times of strongly rising prices. Inflation has eroded the value of their fixed levels of interest and repayment. Shares have provided a better bulwark against inflation, protecting the real value of investors' capital. Despite this, some pundits believe that economic conditions could now make gilts a better long-term investment than shares.

David Kauders, a financial adviser in Taunton who specialises in gilts, says that if inflation is low for the foreseeable future, gilts could become an attractive investment not only for people who want a high investment income, but also for those who normally invest in shares for capital growth. "Provided you stick to conventional stocks with fixed maturity dates, the risks are pretty low," he says. "You have guaranteed repayments so long as you plan to hold the gilts until their redemption date and you get a guaranteed income. Take the positive real yield you can get over and above inflation and bank the money if you don't want the income, save it, buy some more gilts. Compounding works wonders over the years."

With a General Election just around the corner, however, a Labour government is looking increasingly likely. As Labour has traditionally been associated with higher rates of interest and higher inflation, investors may wish to hold back. But if you are still tempted by yields of up to 9 per cent, how do you choose which gilts to buy? Gilts are listed in the business pages of the Independent and other papers, and are classed according to their redemption date. There are five main groups: "shorts", which have fewer than five years to run; "mediums" with five to 15 years until redemption; "longs", which have more than 15 years until redemption; index-linked gilts with payments linked to the retail price index; and undated gilts, which have no redemption date. First decide how long you want to tie up your money. If you want to invest for 10 years, it is most convenient to go for gilts that mature in 10 years.

Mr Kauders offers several tips.

q Don't buy index-linked gilts, where the income and capital maturity value rises in line with inflation. With no signs that inflation is likely to rise in the foreseeable future, the returns could be disappointing.

q Buy stocks that are trading close to their redemption or par value. You know what you will get back, which will be roughly what you invest, and it keeps investment simple.

q Investors who want maximum income may want to consider stocks trading above par, though there will be capital loss on redemption.

q Stocks trading below par can give a tax-free capital gain if you hold them to maturity, but you usually get less income in the meantime. They are referred to as "low coupon stocks". Do your sums to work out how the total capital gain and income after tax compares with the net returns on other stocks. Low coupon stocks may be more suitable for higher-rate taxpayers.

q Avoid stocks with spread maturity rates, where the government has the option to pay you back at any time over a period rather than on a fixed date. You may lose out on the benefit of locking into a fixed return.

q pounds 100 is the redemption price of conventional stocks (that is, excluding index-linked stocks and the small number of stocks that have no redemption). A look at the market price will tell you whether a stock is trading above or below par.

q The running yield tells you the percentage value of the interest payment based on the current market rice. Gross redemption yields give a true rate of return, taking account of any capital gain or loss you will make on redemption, and are a better measure of your return. But the net redemption yield depends on your own tax rate and on how much of the redemption yield is made up of interest and how much is made up of a capital gain or loss. Stockbrokers can usually give you the net redemption yield for different tax rates.

q Look at which month interest payments are made. If you want to receive regular interest payments throughout the year, select several gilts with different payment dates.

You can buy gilts through a stockbroker or through the National Savings Stock Register (NSSR). Forms are available from post offices. Commission through the NSSR is 0.7 per cent on the first pounds 5,000, 0.375 per cent above pounds 5,000, with a minimum charge (on purchases) of pounds 12.50. Interest payment on stock bought through the NSSR is paid gross, but taxpayers will have to pay tax on the interest.