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Comparative Prices
The yields on gilt-edged stocks cannot become much out of line with one another, since the security of income and capital is the same in every case. There are, of course, variations arising from differences in redemption dates, the consequence of which have already been explained (see page 57 for a detailed calculation). As a very general rule it is good policy to buy gilts when interest rates are high, and sell them when interest rates are low. In this way you buy at a low price and sell at a high price.
Price and redemption yield
Changes in prices are not strictly in inverse proportion to the changes in market interest rates, and this is because any change in price introduces a change in the potential capital loss or gain that the holder will make on redemption. Suppose that a 12% stock, standing precisely at par in 2001, is due for redemption exactly five years later. Suppose further that the interest rate level for five-year money, hitherto at 12%, drops to 10%.
If the price of this stock were to be pushed up by the market to 120, at which level the flat yield would coincide with the 10% market level, the holders would stand to make a capital loss in five years' time of £20 per £100 nominal held - a redemption loss of £4 a year. In practice, therefore, the price will tend to rise only to that point where the redemption yield becomes more or less in line with general interest level expectations - in other words, where the running yield less the annual capital loss comes to about 10%. In this case equilibrium will be reached at a price of about 106.5. At this level the flat yield with a coupon of 12% is 11.27%. Allowing for an annual capital loss to redemption of: 6.5
= £1.30, a percentage rate of 1.22% of £106.50.
the redemption yield is about 10% (11.27 - 1.22).
It will now be realised that when a dated stock is bought at a premium (price above par) the running yield should be higher than the prevailing level of interest rates in order to compensate a holder for his potential capital loss. Conversely, when a dated stock is bought at a discount (price below par) the running yield should be lower than the prevailing interest rate to allow for the potential capital gain.
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Yield Comparisons
The yield on short-dated stocks - those that are due to mature within five years - does tend to reflect the current levels of interest in the short-term money market (itself partly determined by short-term expectations of inflation rate). But the yield on the longer-dated stocks follows more the anticipated long-term average interest rate and long-term expected inflation rate.
Buying and selling
Unlike money-deposit investments, gilt-edged stocks can be bought and sold on the market, daily prices being quoted on the Stock Exchange. Indeed most personal holders of government stock... see: Yield Comparisons