Bonds offer UK investors a gilt-edged opportunity

Martin Lewis advises on savings accounts and premium bonds

It has been a long time since ordinary savers put their money into UK government gilts hoping for a decent return, but that has changed dramatically as interest rates soar.

Two-year gilts now yield around 5.25 percent a year and could soon pay 6 percent as the Bank of England battles inflation, but have tax advantages that could give some savers a total gross return of 8 or 9 percent.

Better still, savers can get this without locking up their money, which can be accessed at a few days’ notice. So is this option for you?

Gilts, short for gilt-edged securities, are bonds issued by HM Treasury to fund government spending.

They pay a fixed rate of interest, known as a coupon, along with a cast-iron pledge to return your capital in full at maturity.

Gilts are seen as low risk because the UK government has never defaulted on the coupon or capital, and are mostly bought by pension funds and other global institutional investors.

Ordinary people can buy them too but have got out of the habit after years of poor returns. That is now changing.

Gilt pleasure

Gilts now have plenty to offer savers and investors, said Sam Ratnage, chartered financial planner at wealth manager Tideway Investment: “They weren’t appealing 18 months ago but are now an attractive way to meet short-term savings objectives.”

Gilts are issued in units of £100, with a wide range of maturity dates, between three months and 50 years. Most private investors do not buy newly-issued gilts but older ones, which are bought and sold on the secondary market.

Gilts issued just a few years ago yield as little as 0.25 percent but this means they are cheap to buy, as vendors have slashed prices to attract buyers.

Ratnage said this offers savers an opportunity to generate tax-efficient returns, above and beyond their £20,000 Isa allowance. He takes the example of a gilt that is set to mature in October 2026 and pays a low annual coupon of 0.4 percent. That does not seem a great return but there is a twist. Each £100 gilt now costs just £86 to buy, yet when the bond is redeemed holders get £100.

This gives them £14 for each £86 they invested, which works out as a capital gain of 16.3 percent.

Crucially, that is a tax-free return because there is no capital gains tax on gilts.

Income too

On top of that, the investors will get the gilt’s annual 0.4 percent yield, which will total around 1.4 percent over the remaining term and is subject to income tax at the investor’s marginal rate.

Ratnage said the total return is 17.7 percent, equivalent to 5.4 percent a year, which is better than any instant access savings account: “It is almost as flexible, as gilt investors can typically access their money within seven days if required.”

The total return is even higher for higher rate 40 percent and additional rate 45 percent taxpayers, because of that tax-free capital gain, said Ratnage: “It’s the equivalent of earning 8.6 percent a year gross for a higher-rate taxpayer, and 9.4 percent gross for an additional rate taxpayer. It’s a fantastic opportunity.”

Cash option

Savers have to balance this against the improved returns now available on cash, as rates on fixed-term savings bonds are rising by the day and could shortly hit 6 percent a year amid intense competition from smaller challenger banks.

While basic rate taxpayers can take the first £1,000 of savings interest free of income tax under the personal savings allowance (PSA), this falls to just £500 for higher rate tax payers, while additional rate taxpayers do not benefit from the PSA at all.

Higher earners who have maxed out their Isa allowance and PSA have particular reason to consider gilts. However, they do carry more risk than cash, Ratnage cautions: “While gilts pay a fixed rate of interest their prices do go up and down, which means there is some risk to your capital.”

Graham Smith, investment writer at Fidelity International, said government bonds look tempting at what is a challenging time for stock markets, as inflation refuses to fall and a potential recession looms.

“Gilts certainly look appealing compared to their international government counterparts, as 10-year gilts currently yield about 4.5 percent, well above the 3.8 percent available from US Treasuries and 2.5 percent offered by German bunds of the same maturity,” he added.

Now could be the perfect time to buy gilts. If inflation and interest rates start falling in the months ahead, today’s yields could fall so those locking in today could end up getting an inflation-beating return.

The risk is that inflation does not fall.

Smith said: “Since gilts provide a fixed income to maturity, they tend to be worth less when inflation or interest rates are high or expected to rise further.” Smith said that with economic growth “treading a tightrope”, gilts offer additional security and “the diversification opportunity is becoming harder to ignore”. It is complex, so if tempted, seek independent financial advice.

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