The name ‘gilts’ says it all. Sovereign debt issued by the British government and backed by the Bank of England, gilts are the bedrock of a long-term investment plan, the foundation for pension funds, the girders of insurance schemes. And it’s the same with the sovereign debt of other well-managed countries.

As David Roche, president of investment strategists Independent Strategy explains, such debt is “the touchstone by which other riskier financial assets are priced.”

The massive amounts of sovereign debt issued by USA and western Europe to save their own or other economies such as Greece’s has rewritten the rules. The world is now awash with sovereign debt, some of it of dubious quality, and the investment world worries if it’s all going to get paid back.

The €750 billion (£650 billion) that EU nations, European Central Bank and IMF stumped up to rescue Greece illustrates the size of the problem.

The result is a mounting fear of contagion – that is, one country’s excessive issues of sovereign debt dragging down the value of another. Virtually overnight, gilts and ‘sovs’ have become, if not risky assets, certainly not the unimpeachable instruments they have been for half a century or more.

As Daniel Sheppard of Deutsche Bank Wealth Management says, expressing fears about future downgrades as a result of the contagion: “We are in the age of worrying about sovereign debt,” he confirms.

Gilt ridden
There’s an awful lot of sovereign debt out there compared with happier times. The public, that is, government-issued debt of most western European nations, is running at over 100% of gross domestic product after rising by nearly 70% in the last four years.

In the early years of the millennium, this would have been considered an unthinkable, even horrifying scenario. Indeed, the last time we saw this was in the 1939-45 war when governments were printing money like confetti to feed the war machine.

So does it make any sense to invest in gilts or their international equivalents? Certainly, argues Jeremy Batstone-Carr, an analyst at Charles Stanley and an authority on sovereign debt. Just one reason for his continuing faith in gilts is that they will continue to form an albeit reduced bedrock of pensions funds and other long-term savings programmes. “Actuaries will continue to encourage pension-fund managers into bonds,” he predicts. However, as we’ll see, the somewhat tarnished world of gilts – in the western world anyway – has changed some of the rules of the game.

Vested interest
So what exactly is, or was, so great about a gilt? First, it’s a loan to the government at a fixed rate of interest – the coupon. As such, it has the absolute backing of the government. On the date of redemption, investors will get their money back, plus interest along the way. Second, a gilt/bond delivers what’s known as a yield. That is, a combination of the nominal rate of interest, say 5% over the life of the instrument, plus capital gain. These interest payments are sometimes known as the ‘running yield’. The upshot is that however badly a gilt turns out because of outside economic forces, holders can always bank on a stream of interest payments.

However, it’s the capital gain – or loss – that most concerns bondholders. Although gilts are described as fixed-interest instruments, they aren’t really because the return fluctuates according to the price at which the gilt is bought and sold. This is known as the gross redemption yield including capital gain before taxes, if any. Additionally, the capital gain depends on prevailing levels of inflation and of interest rates over the life of the bond. A general rule of thumb decrees that gilt prices rise when interest rates fall. Obviously, gilts with higher coupons become more attractive when succeeding paper is issued at lower coupons.

Of course, the opposite applies. Rising interest rates can soon turn gilts with low coupons into dross. This is why the value of gilts and sovereign bonds in general fluctuate from month to month, year to year, and sometimes day to day as we’ve seen with Greek bonds.

Skilled bond investors watch inflation rates like a hawk. Nothing cheapens a bond faster than rampant inflation because it drives up interest rates. Fortunately, the weight of opinion is that the western world is heading into a sustained bout of deflation, which is generally good for bonds. And if it doesn’t, index-linked bonds are one way of covering that risk.

That doesn’t mean that sovereign bond-holders haven’t got their fingers crossed. ‘A repricing of sovereign debt as dangerous debt would be an earthquake for financial markets,’ adds Roche, who has just written a book with economist Bob McKee called Sovereign DisCredit about the dangers lurking in the current situation.

Why? Because these nations run conservative public finances with all the right fundamentals: low debt, strong economies, low budget deficits, current account surpluses, healthy foreign exchange reserves and high sovereign credit ratings.

Therefore, in a changing of the guard, savvy investors are buying into the bonds from countries such as Brazil, Russia and Egypt among many others. The implication, point out professional investors, is that there’s nothing wrong with sovereign bonds. What’s important is the country that issues them.

Timing is everything The lesson for gilt-buyers in this more volatile world, explains Jeremy Batstone-Carr, is to take a much more active interest in their investments. ‘The old days of buy-and-hold are well and truly gone,’ he warns.

‘Once the investment is made, investors must become much more involved in their portfolio.’ This means the term of a gilt – whether two, five or 30 years – is less important than its value at any given time.

‘There should be no real time element,’ he explains. ‘The only important factor is its performance.’ However, in a turbulent world, most investors in sovereign bonds are going for the medium-dated paper of around five years. ‘Anything short or long looks risky,’ adds one source.

And yet, the world’s biggest investors continue to mop up sovereign debt, but not in the same way as before. Pimco, the world’s second largest owner of bonds, is buying into emerging markets and reducing its exposure to Britain and certain other western nations. Similarly, Aviva Investors has more than doubled its holdings of these assets.