Depository Receipts and Index Linked Gilts

Q. What is a Depositary Receipt?

A: Global Depositary Receipts (GDRs) and American Depositary Receipts (ADRs) consist of negotiable certificates issued by big investment houses (banks) which represent ownership of a set number of a company's shares. Usually, these instruments can be listed and traded independently from the underlying stock and are commonly used by companies based in emerging markets to raise capital. A Depository Receipt is in essence an agreement between the issuer and the company for whose shares the depositary receipt is based. Once the issuing bank buys the shares, this is deposited at a custodian bank located in the same country where the company is located, and then issues the depositary receipt representing the ownership interest in the stock.

The major issuers of depository receipts are Citibank, JP Morgan, Deutsche Bank and the Bank of New York Mellon. Most Global Depository Receipts are listed on the LSE while American Depositary Receipts are listed on a USA exchange - the New York Stock Exchange, the American Stock Exchange or Nasdaq. Global Depository Receipts and American Depositary Receipts are usually quoted in USA dollars with dividends also being paid out in dollars. GDRs are traded on the International Order Book, an electronic order book set up by the London Stock Exchange.

The prices of receipts are dependent on its depository ratio i.e. the proportion of receipts in relation to the underlying stock. Depository receipts are a form of derivative and can thus be created or cancelled depending on the forces of supply or demand which means that the instrument will trade in line with the underlying stock price.

Q. What are Gilts?

A: Gilts are a fixed-term, fixed-interest loan to the government. The government sells their promise to repay (originally printed on gilt edged card to symbolise the gold-plated promise, hence the name) at auction. Under normal circumstances, the government receives bids equal to about twice the amount of gilts available for sale. They then sell to the highest bidders.

Q. In one instant this year the government wasn't able to sell all offered gilts - does this imply that Brown is having trouble...

i.e. having trouble selling the debt he hopes to finance his bank rescue and stimulus packages with?

A: In that case the auction was uncovered meaning that the government received less bids than available gilts - leaving a temporary deficiency in funding which in this particular case wasn't that big; 120 million, so it could always be added to the next few months auctions. However, this episode highlights that investors are becoming more nervous about lending money to the government especially for long durations (40 years in this case) and it is an omen that the government may find that it has to offer higher interest rates to attract investors unless it can low its' borrowing requirements.

However, this is only part of the story - the government does not really need to sell the gilts to investors as the Bank of England can buy as many bonds as they wish to sell at whatever rate they please. They do not really need to sell bonds to third party investors - and of course the Bank of England printing money to buy the bonds is equivalent to the government doing so. Unfortunately, few people understand this and even fewer are aware of the implications as it almost seems unreal to normal people that we have a monetary system based on such a crazy system!

The system is in reality quite clear in that government officials can always say to the people: The Federal Reserve/Central Bank will only lend money against highly-rated bonds like government bonds. People regard government bonds as solid and safe so this provides the illusion that the monetary system is stable. Of course they don't tell the people that the government can print as many bonds as it needs and it always has a buyer -(the Central Bank) which can buy the bond and immediately proceed to print money to the full amount of the bond issue. The effect of this is that the central bank will then hold both the bond without disrupting its reserves whereas the government has acquired all the printed money.

As an example consider one of the grimmest episodes involving the Federal Reserve (United States) bailout of AIG - after the bailout the Federal Reserve issued a report stating that it had almost spent all its reserves (which are nothing but numbers on a spreadsheet) which gives people the impression that there is a limit on to how much the Federal Reserve can spend. Of course this was a special case as the Federal Reserve was not even lending the money against collateral here but it was BAILING out AIG and buying their shares. The problem with the reserves didn't take long to resolve as a few days later, Paulson at the Treasury started issuing out a new type of bond that the Federal Reserve could buy to allow them to immediately print more money against this new collateral. The funds that the treasury took injected into the Federal Reserve to shore up the Federal Reserve's own balance sheet. This money was then put into AIG. However, this scheme with bonds and collateral is just a distraction from the real facts. The bottom line is that the Federal Reserve simply printed money and gave it to AIG.

As Henry Ford remarked: 'It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.' Keynes made a similar observation, noting that the debasing of the currency (via the monetary system) takes place in a manner which 'not one man in a million is able to diagnose'.

Q. My Index Linked Gilts fund is falling in value, will it recover? What's the outlook for gilts in times like this?

A: Gilts are likely to preserve their value reasonably well under all foreseeable market conditions (excluding default of the UK government, or catastrophic deterioration in government financing).

However, like all non cash investments, there is a degree of volatility in price. Index-linked gilts derive most of their return from inflation. With the threat of high inflation, they have therefore commanded a high price (and therefore a low yield) as the inflation component has fueled demand. By contrast, in a low inflation environment, or even deflationary environment, their yield will fall, and therefore there is less desire for these, and they command a lower price.

Perhaps you should regard buying index-linked gilts as store of wealth, rather than cash - in the event of high inflation, you are protected. In the event of deflation or low inflation, although your nominal returns may be low or even negative, you should see a slight rise in purchasing power.

Bear in mind that the index-linked gilts have only dropped in the low single figures - stocks have dropped nearly 20% in the last few months.

I've kind of hedged my bets a bit buy buying some fixed income government bonds (mixture of governments and currencies) and some index-linked gilts.

Good to know: Index-linked gilts pay coupons which are initially set in line with market interest rates, however their semi-annual coupons and principal payment are adjusted by the Retail Prices Index. Bad sentiment with low inflation would be good news for fixed interest gilts, high inflation is good for index linked gilts.

Q. 'If you buy index-linked gilts you get protection whatever the level of inflation. In fact deflation is best as there is a stop-loss on them - they do not go down in value in any year in which there is deflation.'

A: No you don't. Index linked gilts index both inflation and deflation. If you get deflation, both the capital and interest payments on an index linked gilt are reduced. Yes, if you buy a £100 index linked gilt, hold it for 10 years during 1% deflation - the underlying capital will be reduced to £90.40 - the interest payments you receive during the term, will also be reduced in proportion with the underlying capital (e.g. a 1% index linked gilt would pay £1 in the first year, but only 90p in the final year).

Index-linked sovereign bonds from other countries (e.g. Canada, US and much of Europe) do include a deflation floor, which will prevent the capital reducing below it's original value. However, gilts do not include this.

Gilts are tradable, so they have a market value which is not just determined by their inherent value (value of their capital and interest), but by supply and demand for ultra-low risk debt, as well as inflation/deflation expectations and the availability of better yielding investments. [This market value also applies at issue, as they are issued at public auction].

Q. How does inflation affect an investment portfolio?

A: Inflation basically kills lower performing investment portfolios. To illustrate this point let's examine the case of losing 30.7% of your investment in the rolling year to Jan 2009. 30.7% would be an average loss for a fund invested in equities in the severe recession period from mid-2008 to beginning of 2009. So if you had originally invested £100,000 in a fund in 2008 you would now have £69,300 left in your account by Jan 2009.

To visualise how this situation might play out there is a table at the bottom. It compares the years it takes to get back to £100,000 with a range of rates of return. For example if the portfolio was to return only 5%, and inflation was running at 5%, the portfolio would never get back to its starting equity of £100,000.

Effects of Inflation

 ...LIBOR and the Bank of England

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