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UK government bonds – also known as gilts – are debt securities issued by the British government in order to finance public spending. They are a popular asset class for investors because they carry less risk than shares and also provide a guaranteed income.
Gilts are considered to be one of the lowest-risk investments because they have the full backing of the British government. A gilt is effectively an IOU issued by the Treasury, promising the holder regular interest payments in return for lending the UK government their money.
Most gilts pay the holder a fixed cash payment (called a coupon) every six months until the maturity date, at which point they receive the final coupon payment and the return of your original investment. Investors can hold on to them until they mature, or they can sell them on the secondary market, like company shares.
Short-term gilts have maturities of less than one year to around five years. Medium-term gilts range from five years to 15 years in maturity. Long-term gilts have maturities exceeding 15 years, with some bonds even extending up to 50 years. Gilts with a longer lifespan (such as 30 years) tend to have a higher interest rate than those maturing in the next couple of years.
What are gilt yields?
The yield is the annual return an investor will receive for holding a gilt over the next 12 months. The gilt yield is calculated by dividing the annual coupon payments by the current market price. Gilt yields are influenced by various factors, including the outlook for interest rates and inflation, as well as the market demand for gilts.
Bond prices and yields move in opposite directions. So when demand for gilts is high, prices tend to rise and yields decrease. Conversely, when demand is low, prices may fall and yields increase.
Why have gilt yields risen?
Since the end of the pandemic, interest rates have soared as the Bank of England tries to get a grip on inflation. Changes in interest rates have a significant impact on bond prices, especially when they are rising and forecast to keep going up.
Interest rates and bond prices have an inverse relationship, meaning when interest rates increase, bond prices generally tend to go down. When interest rates fall, bond prices rise. This is because when interest rates increase, new bonds issued at higher interest rates offer higher coupon rates and yields than older bonds that were issued when interest rates were lower (which are therefore less valuable).
The only way for older bonds to remain competitive is to reduce their prices, which leads to an increase in their yields. So after a prolonged period of unusually low yields due to a decade of low interest rates, yields have been rising steadily over the past year.
What are the tax advantages of investing in gilts?
Individual investors are subject to income tax on the interest earned from gilts, but they are completely exempt from capital gains tax (CGT). This means you won’t have to pay any CGT on any of the profits you make if you sell a gilt or when it reaches maturity.
This exemption is particularly useful for higher rate taxpayers who would otherwise have to pay 20% CGT. You also won’t pay any tax on gilts if you hold gilts in a tax-efficient wrapper, such as an ISA or a Self-Invested Personal Pension (SIPP).
Why it might be a good time to consider gilts
Some are now paying yields over 5%, which is incredibly generous compared with recent years. For example, on 21 July 2023, a UK gilt with an expiry date of 31 January 2025 paid a coupon of 0.250% and traded at £92.40, providing an annual equivalent yield of 5.05% if held to maturity*.
While this figure is slightly lower than the best available savings rates, once the ISA allowance and the £1,000 personal savings allowance have been used up, it becomes more attractive, especially for higher and additional rate taxpayers. We calculated that the yield after tax for a bond expiring on 31 January 2025 was 4.94% for higher rate taxpayers and 4.93% for additional rate taxpayers.
Despite the Bank of England’s efforts to bring inflation down, it is still high and further interest rate rises are expected. The longer inflation and interest rates remain high, the more gilt yields are likely to rise. Short-dated gilts (with a maturity of five years or less) have seen yields reach their highest in 15 years, even higher than yields on 10-year debt.
For investors worried about increasing inflation expectations, inflation-linked gilts provide a reliable means to safeguard their capital if held to maturity. These securities provide the added benefit of both the principal and interest being tied to inflation. This feature ensures investors receive a return that adjusts with the cost of living, helping to protect the real value of their capital.
There are also some gilts in the market at the moment that were issued shortly after the Covid-19 pandemic when interest rates were still low. Since interest rates have been rising, these gilts have been trading at a significant discount to their face value. This can sometimes provide an opportunity for investors who are able to withstand the daily volatility in prices and hold the gilts until they mature.
The role of gilts in a diversified portfolio
Another benefit of gilts is that they provide investors with a potentially safer alternative during times of uncertainty. While gilt prices can be influenced by changes in interest rates, their low correlation with stock markets can make them an excellent diversifier.
By incorporating gilts as part of a diversified portfolio, investors can mitigate risk and balance their exposure to different asset classes. Gilts with longer maturities tend to be more susceptible to interest rate fluctuations than those with shorter maturities, so investing across a range of gilts with varying durations can help spread the risk.
Benefits of advice
When it comes to investing in gilts, it is important to speak to an experienced adviser or investment manager who can help you navigate the intricacies of the market and make informed decisions. At Investec, we offer institutional access to the gilt market, meaning we can trade at more competitive rates (and therefore offer potentially higher return) than retail brokers.
By speaking to an adviser or investment manager, you can also ensure your investment strategy aligns with your financial goals and risk tolerance. Our team possess a deep understanding of the gilt market and can provide tailored advice to help you make informed decisions, maximising the potential benefits of your investments.
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Important information
The risks and characteristics of bonds differ markedly from cash deposits. Gilts are marketable securities and their prices change subject to market conditions. Please ensure you are familiar with the potential advantages and disadvantages of holding gilts before proceeding with any investment.
The taxation basis of gilts is set out in section 115 of the Taxation of Chargeable Gains Act 1992 and, as with all tax rules, may be subject to change. Tax rates are correct as of October 2022. Income tax bands are different if you live in Scotland. References to taxation are based on our current understanding of the legislation but we do not represent that it is accurate or complete and it should not be relied upon as such.
We do not offer tax advice and this content is designed for general use, and so cannot be considered personal to your circumstances or your financial position. If you are unsure, please seek independent advice.
The value of investments and the income derived from them may fluctuate and you may not receive back the amount originally invested. Past performance is not necessarily a guide to the future. Investments and investment services referred to may not be suitable for all investors.
Important information
The information in this document is believed to be correct but cannot be guaranteed. Opinions, interpretations and conclusions represent our judgment as of this date and are subject to change. Past performance is not necessarily a guide to future performance. The value of assets such as property and shares, and the income derived from them, may fall as well as rise. When investing your capital is at risk. Copyright Investec Wealth & Investment Limited. Reproduction is prohibited without permission.
Investec Wealth & Investment (UK) is a trading name of Investec Wealth & Investment Limited which is a subsidiary of Rathbones Group Plc. Investec Wealth & Investment Limited is authorised and regulated by the Financial Conduct Authority and is registered in England. Registered No. 2122340. Registered Office: 30 Gresham Street. London. EC2V 7QN.