Why investors are snapping up short-dated gilts yielding 0.25%: The tax-friendly benefits of low rate bonds

Savings rates have climbed above 6 per cent but some investors are rushing to buy short-dated gilts that might pay just 0.25 per cent, thanks to a tax perk that massively boosts returns.

While savers can secure a 6.2 per cent government-backed return over one-year on NS&I’s Guaranteed Growth Bonds, wealth managers say some savvy investors are picking up an even better after-tax return from government bonds paying much less.

And depending on the rate of tax you pay, some gilts with short maturity dates can give a better guaranteed rate of return than the best savings accounts. 

This is because investors buying them at below par prices can pick up £100 in the near future for considerably less now – and turn an almost cast-iron future profit capital gains tax-free. 

Tom Becket, of Canaccord Genuity, says that for some additional rate taxpayers, backing short-dated gilts has brought returns that they would have needed a taxed savings account paying almost 9 per cent to match. 

The only way the bonds wouldn’t pay out would be in the unlikely event the UK defaulted on its debt. 

Why investors are buying short-dated gilts

Investors have been rushing to invest in short-dated gilts, with wealth managers and investment platforms observing demand going up dramatically over the last year.

Investment platform Interactive Investor has seen a whopping 721 per cent increase in fixed income trading – of which gilts are a type – this year, to the beginning of September, compared to same period last year.

A gilt is an IOU note issued by the UK, promising investors regular interest payments – known as a coupon – in return for lending the government their money over a set period. Investors are also promised the return of their initial investment at the end of the lending period. 

Gilts are bought when they are issued at what is commonly called their par value, for example £100. They pay interest, known as the coupon, which is expressed as a yield based on how much that is vs the gilt’s par value. For example, a £100 gilt paying £5 would have a 5 per cent yield. 

The UK stands behind gilts and would need to default on its debts for them not to pay out. 

Gilts can also be traded second hand and depending on how much demand there is for them, the price they can be bought at may be higher or lower than their par value. 

This affects the effective yield these second-hand investors get, as someone who buys a 5 per cent coupon on a £100 bond for £80, will actually be getting £5 from £80, so a yield of 6.25 per cent.

Yields move in the opposite direction to prices for bonds traded on the open market, so when a yield moves higher, the gilt’s price moves lower.

As interest rates have ticked up, so have the returns that the government must offer on new gilts to get investors to buy. 

The knock-on effect has been to push down demand for existing gilts traded on secondary markets that were issued some years ago and which offer much lower interest rates, depressing their price.

These gilts are trading below par, meaning the guarantee of £100 back can be picked up for around £90. But if investors hold them to maturity, they will secure both the interest coupon until then and get £100 back.

For UK investors who buy a gilt that is trading below par, the recovery back to par – or capital appreciation – is free of capital gains tax.

How short-dated gilts deliver tax-friendly returns 

If an investor were to buy the gilt that matures on 31 January 2025, which has an annual income or coupon of 25 basis points – just 0.25 per cent – at the time of writing (late September 2023) that bond is trading at about 94.26 pence in the pound.

That investor would be accepting a paltry interest rate compared to the best savings accounts that pay 6 per cent, but they also get the capital uplift of 5.74p for the movement from 94.26p to 100p. And crucially, this is CGT-free. 

This makes the equivalent total return, when adjusted for tax, very attractive at this point in time.

The rate of return delivered by a bond’s coupon and the uplift to its par value, if held to the end of its life, is known as the yield to maturity. 

Becket explains: ‘With the gilt maturing in 2025, your yield to maturity is 4.79 per cent, with roughly 25 basis points of that coming from the coupon. The rest is CGT-free.’

Yields to maturity look yet more rewarding for higher rate and additional rate tax payers when compared to taxed savings interest. The personal savings allowance is up to £1,000 of interest but only for basic rate taxpayers, higher rate taxpayers get this cut to £500 and additional rate taxpayers get nothing.

An even shorter-dated gilt maturing on 31 January 2023 has a coupon of just 0.13 per cent, but the yield to maturity is 4.93 per cent – the equivalent of 8.9 per cent for an additional rate taxpayer. 

Becket continues: ‘If you are a additional rate tax payer, paying 45 per cent income tax, if you were to gross up that return and have an equivalent yield at your rate of income tax, that rate of return would be pushing 9 per cent.’

‘Because of the distortion in the gilt market, this makes for a compelling opportunity for investors and It is quite difficult to justify against them at this point in time.’

As a result, Becket says: ‘The time is now for investing in short-dated gilts.

‘From years in the doldrums where returns from bonds were close to zero, as interest rates have ticked up, so have returns on gilts.

‘But when weighing up the pros and cons of short-dated gilts, cash and fixed term deposits – plus the tax advantages of investing in certain gilts that are trading substantially below par – it’s clear that investing in gilts is much more advantageous than it has been for years.’

What’s changed in the gilt market?

The crash in interest rates after the financial crisis made the investment case for UK gilts based on their yield weak for most of the last 14 years .

Instead, investors bought them for the element of supposed safety they bring to a portfolio, as they are backed by the UK govenrment, and because they speculated on gilt prices rising as interest rates headed even lower.

In 2016, the yield on 10 year gilts was 1.5 per cent but before the financial crisis, you could often buy gilts with yields of 4 or 5 per cent.

This decline in yields culminated in 2020 when 20-year gilt yields slumped at one point to around 0.1 per cent.

The sharp reversal in interest rates that began in December 2021 has dramatically changed this picture. Base rate has risen from 0.1 per cent to 5.25 per cent to combat inflation and UK gilt yields have risen substantially.

Becket says: ‘Today we are in a very different situation with fixed-interest markets. which some have likened to a new paradigm, but really we have just gone back to the situation we used to be in before the financial crisis

‘Once again, fixed interest markets including UK gilts, have become more investable.’

How long will the opportunity last?

The opportunity for returns on below-par short-dated bonds now will expire when as this era of bonds mature – and could be eroded if demand surges.

Becket says: ‘The closer we get to maturity of the gilts, the more these situations will expire, so it is important to exploit these opportunities relatively quickly to benefit as much as you can before we see these things fall back towards par.

The interest rate environment is also a factor.

If interest rates continue to go up but stop at lower levels than currently forecast and then plateau before coming down slowly – attractive gilt yields could stick around for longer.

This could be the case for a gilt maturing in 2033 where the coupon is 0.875 per cent and the bond is currently trading at 72p in the pound. This means you can get that 28p of capital uplift back to par CGT-free. That reflects the extra degree of risk in holding for much longer to maturity.

How to invest in gilts direct

The demand for gilts has led to Canaccord Genuity launcing a Gilt Portfolio Service in response to the resurgence of fixed income investing in the last year.

But a minimum investment of £100,000 is needed which is a major hurdle for most investors other than the very wealthy.

If you have a smaller amount to invest, you can buy gilts through an investment platform like Hargreaves Lansdown, AJ Bell, Interactive Investor or Killik & Co, although this often isn’t as easy as buying shares or funds.

For example, you can deal over the telephone with AJ Bell by calling and asking for the gilt you want.

Interactive Investor offers the whole of market of gilts available to retail investors. Where they are not available to trade online due to pricing issues, for example index linkers, the platform says it will honour the online rate.

There is no minimum investment, because different bonds will have different nominal sizes. But a trade as low as £25 wouldn’t be unusual.

Hal Cook, senior investment analyst at Hargreaves Lansdown warns that investors should be careful when selecting gilts, as this is very different to putting money in a savings account – two bonds with same maturity date could offer completely different returns.

He says: ‘Before you buy you need to be clear what you’ll pay today versus what you will get back at maturity – and the regular payments you receive along the way – the combination of the two will make up your return.

‘For example, the current yield on the five-year UK gilts is 4.1 per cent, which is what you would lock in as your total annualised return if you bought it today and held until maturity.

‘You’re comparing apples and oranges to hold this up to the return on a fixed rate savings account, but just for context, over five years you can get over 5 per cent at the moment.’

The return on gilts will be based on holding to maturity. If you need to sell the gilt before the five years are over, you may need to sell at a loss, so investors should be aware of this risk.

On top of this, as with any investment, there may be charges when you deal or hold gilts, so you need to factor this into the returns on offer too.

Gilts versus savings accounts

In terms of the advantages of gilts over cash savings, it can be argued that they offer a better effective tax rate compared to cash on deposit if you have a larger pot.

The sharp rise in interest rates has meant that many savers could face the prospect of exceeding their annual Personal Savings Alllowance and being taxed on their interest income. 

Read more here: Will you be hit by a tax bill on your savings as rates rise?

You need just over £16,000 earning 3 per cent interest to breech your £500 annual interest tax-free allowance if you are a higher rate taxpayer, and anything above that is paid at 40 per cent.

By contrast, you pay no tax at all on the capital uplift on gilts and the coupons are so low you would have to be investing huge amounts to pay any tax on the interest they bear.

But you are investing and taking risk in a way that is different to holding money in a savings account. If you are in any doubt, seek financial advice before investing. 

Content source – www.soundhealthandlastingwealth.com