What is Gilt-Edged Switching

Gilt-edged switching involves the purchase or sale of high-quality gilts typically issued by the U.K. government, and the simultaneous selling or buying of another maturity or type of gilt, in an attempt to profit on the performance differential.

Typically, gilts are very safe investments, since the U.K. government is known for paying its debts. Thus, they carry next to no default risk. They are the British equivalent of U.S. Treasury securities. The name gilt comes from the original bond certificates issued by the British government, which had gilded edges.

Gilts can be of two types: conventional gilts issued in nominal terms, and index-linked gilts, which are indexed to inflation and are similar to Treasury inflation-protected securities in the United States.

BREAKING DOWN Gilt-Edged Switching

Gilt-edged switching is a way for large investors to purchase gilts of one maturity to finance the purchase of gilts of another maturity. Typically, this involves selling gilts of shorter-dated bonds to finance the purchase of longer-maturity gilts. However, in times of economic stress, it also involves the selling of longer-maturity gilts to finance the purchase of shorter-dated securities.

At times, gilt-edged switching, at times, also involves buying of nominal gilts to fund the purchase of index-linked gilts, or the buying of index-linked gilts to fund the purchase of nominal gilts.

The term "gilt" primarily is associated with the United Kingdom, although India's government securities also use the name gilts due to the country's history as a British colony. What’s more, bonds issued by blue-chip companies known for their high-quality and AAA ratings sometimes go by the name gilt-edged securities, as well.

This wide definition of gilts also means that gilt-edged switching sometimes involves the simultaneous buying and selling of different types of investment-grade bonds, all of which fall under the term gilts.

For example, bullish investors tend to sell gilts and buy high-grade corporate bonds bonds that carry risk, and therefore, higher yields, during times of economic strength. Conversely bearish investors tend to buy gilts and sell high-grade corporate bonds with default risk when they fear economic contraction. This, too, is thought of as gilt-edged switching.

Pros and Cons of Gilt-Edged Switching

In normal markets, gilt-edged switching can earn large institutional investors an incremental return over investing in one type of gilt alone. Moreover, it often requires a small cash outlay, since borrowing one security type pays for the purchase of another security type, if all goes well.

However, trouble ensues when the market moves against investors’ positions. For example, an investor shorting one-year gilts to fund the purchase of five-year gilts may be caught off guard if the yield curve moves counter to the investor’s expectations, at which point the investor must buy to cover.