As with all forms of assets gilts pay a annual yield, known as the coupon in the gilt edged market. However the coupon isn't a perfect guide to the interest rate the Government had to pay when they issued the gilt because stocks are sometimes issued at a premium or discount o their par value.
The prices of gilts are determined primarily by interest rates but are also influenced by news and technical influences.
Firstly let us examine the effect of a change in interest rates on the price of gilts. This is best explained by a theoretical case involving 3 different stocks#. Suppose that in 2001 the DMO decided to issue 3 stocks with the following details#:
Price Income Yield Redemption Yield
Short-dated 4.5% 2003 100 4.5% 4.5%
Medium -dated 4.5% 20010 100 4.5% 4.5%
Long -dated 4.5% 2025 100 4.5% 4.5%
Suppose that a year later the UK economy has began to deteriate and that there's evidence of inflation growing, and the US economy, a major importer of our goods, is slumping and investors are demanding higher yields to compensate. If the DMO wanted to issue a new gilt at this point they would have to offer a yield of, for example 6%, to persuade investors to buy. It's clear that investors wouldn't buy the 3 stocks above at a price of 100 and a redemption yield of 4.5%. So what price would the investors buy the old stocks at? The prices would have to fall in the market until they offer a 6% redemption yield which investors now expect. The new yields and prices expected are shown...