Gilts are a viable tax-free alternative to the upcoming reduction of the cash ISA allowance for under-65s next year, according to Sarah Coles, head of personal finance at AJ Bell, but one fund manager has warned investors they are a “one-trick pony”.
UK government bonds, or gilts, are essentially loans to the government in exchange for a regular payment known as a coupon. They vary in length – think of it as the time your money is locked away for – and at the ‘maturity’ date at which the loan ends, investors get the face value of the bond back.
“Most people know them as an investment class, which they usually access through a bond fund. They hope to take advantage of the income from the coupon and any changes in price,” said Coles.
“Gilt prices will rise and fall with demand, so investors aim to buy low and sell high. This comes with the investment risk that the price of a bond can fall before you sell it, so you could lose money. It’s very different to the risk profile of cash savings.”
This has not been a lucrative strategy in recent years. The average fund in the IA UK Gilt sector has lost investors 19.8% over five years and 5.7% over 10 years – although they have eked out a gain of 2.8% over the past 12 months.
Funds in the IA UK Index Linked Gilts sector, which buy bonds where the income rises in line with inflation, have actually performed worse, with an average loss of 34.3% and 10.6% respectively over five and 10 years.
The other option is to buy individual bonds through investment platforms, giving investors the option to choose how long they want to lock their cash away for
“You need to be comfortable with the fact that if the UK government defaults on its debts, you may not get the full repayment, but that’s highly unlikely,” said Coles.
While the income is nice, perhaps the more lucrative part of the equation is capital gains, which are based around the cost of the bond. Gilts are priced at £100 and that is the amount investors will receive upon maturity, but there are times when investors can buy the bonds for less than that.
For example, Coles noted that one bond issued during the pandemic and set to mature in January 2028 has a coupon (yield) of just 0.125% but is priced at £93.20. So in two years an investor will get back the initial price of £100 for every £93.20 they put in – a 7.3% return.
These low-income, high capital return gilts are particularly attractive to those looking to get a tax advantage, said Coles. While any interest earned from the coupon may be subject to income tax, any rise in value is free from capital gains tax.
“Frozen income tax thresholds – and the lowering of the additional rate threshold – have made tax-efficient saving even more vital” she said.
“Crossing an income tax threshold means your personal savings allowance halves or disappears altogether, and the excess is charged at your new higher marginal rate. This, combined with cuts to the cash ISA allowance for those under 65 from April 2027, means more people paying more tax on their savings.”
But there is no such thing as a free lunch, according to Martin Coucke, co-manager of the Schroder Strategic Bond fund, who warned that gilts are “a one-trick pony”.
“You're not diversified at all and you’re taking basically one big risk when you're investing in gilts,” he said.
“Which part of the curve you’re investing in is important,” he added, noting that investors who took out bonds with a maturity of two-to-three years in 2022 “would have done okay” but anyone who put their cash in a longer-dated bond two years ago is “probably losing money” in real terms now.
He suggested that short‑dated gilts offer retail investors “decent entry points” given the current yields on offer, but said the asset class as a whole hasn’t been a great investment for most.
He argued in favour of investing in a strategic bond fund, which is diversified across government bonds from around the world as well as corporate credit.
“If you look at the performance of a strategic bond fund against a gilt fund, the outperformance is tremendous. So I would definitely recommend someone looking to get exposure to bonds to actually buy the right strategic bond fund rather than buying a gilt fund,” he said.
Even those who have made the right strategic decisions with gilts – buying short-duration bonds and making money from the capital gains – would have still underperformed a strategic bond fund, he noted.
“That's something to bear in mind,” he concluded.