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Bond of the Week: 12 April 2011

War Loan drifts down towards the bottom of the range. Is it time to buy?


War Loan is back down at the bottom of the range again. Between 1998 and the current day, this undated gilt with its 3.5% coupon (no fixed maturity) has sat within a price range roughly bounded by 70 and 90p. Now trading at 71.25p, the bond has a running yield of 4.9%.

This is a generous yield for gilts. Very long-dated conventional gilts such as the Treasury 4% 2060 yield circa 4.3%. So why the chunky yield premium for our old friend?

Many market participants put this differential down to the poor liquidity of the War Loan. However, this is only partially true. The real reason for the yield premium is the implied call option imbedded in War Loan. Investors will factor in that the bond is callable at any time by the government. Should long term interest rates in the UK drop sharply below 3.5% (as been the case in Japan for over 15 years), the government can, and almost certainly will, call War Loan. However, holders of dated super-longs such as 4% 2060 can continue to enjoy their coupons for many years to come. Thus, a risk premium is priced into the War Loan and other undated gilts. 

So should one take a punt? Firstly, liquidity in War Loan has diminished over the years, so prospective buyers will have to make sure that they deal efficiently. Assuming that one can get in at a good price, the bond is well positioned for a medium-term trade (think months rather than days). Holders will be receiving an attractive running yield and the range-trading price action to date suggests that there is a good probability of exiting the position at a higher level in due course. Other undated gilts such as the Treasury 2.5% are also worth looking at - the lower coupon provides more gearing for the trade. Consider also that capital gains on gilts are tax free.

Mark Glowrey

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