Capital gains tax on gilts

A strange time to talk about capital gains tax on gilts1 – after two years of historic losses from government bonds!

Forget gains! Just not losing money would be nice for a change, right?

Okay, so most Monevator readers will know that bonds have had a bad run. That their prices began to fall as inflation and interest rates took off. And that gilts then cratered in the wake of the 2022’s disastrous Mini Budget.

But the less appreciated thing is that gilts – and other bonds – fell so sharply that their expected return profile has now changed dramatically.

At the start of 2022, gilts were trading well over par.2 Investors hungry for yield had bid up gilt prices for a decade.

This meant a capital loss was guaranteed, sooner or later, because the money you’d get back when the gilt was redeemed would be less than you’d paid when you bought the gilt above par value.

Now though, most gilts are priced below par.

So as well as the regular coupons you receive as a holder of a gilt – interest, essentially – you’ll also make a profitable capital gain if you own the gilt when it matures.

Gilts: a turnaround story

This all matters a lot for investment – not least because we’re hearing lots of readers talk about dumping their UK government bonds.

Even passive investors!

Caught between a rock and a hard place in trying to diversify their portfolios, people held gilts for years even as the outlook for returns dwindled.

Now though, after a couple of terrible years for government bonds, some are throwing in the towel.

For example, Vanguard’s more bond-heavy LifeStrategy funds saw billions in net withdrawals in 2023.

However before you follow suit, do understand the reversal in gilts’ prospects.

Today even index-linked gilts are sporting a positive yield-to-maturity (YTM).

This means you can now guarantee a return above inflation, by buying and holding these government bonds until they mature.

In contrast, as recently as the end of 2021 you had to pay the government for the privilege of inflation-proofing your capital.

Very long duration index-linked gilts were on a YTM of negative 2%!

The picture is more opaque when it comes to government bond funds, which is how most people hold their gilts.

That’s because the funds hold a rolling stock of gilts, which are managed in order to maintain a steady duration.

However they own the same underlying securities – gilts – and the overall message is the same.

Gilt prices – and hence yields – will probably continue to be choppy, until the outlook for inflation and interest rates calms down.

But the important thing is not to judge UK government bonds by what they’ve done recently. Consider what they are priced to do in the future.

Nice curves

Vanguard foresees markedly higher expected returns from bonds from here:

Source: Vanguard

And here’s what M&G Investments’ pros – the self-styled Bond Vigilantes – had to say when the prospects for linkers turned positive:

Inflation protection is looking attractive (or sensible) again. The last month has pretty much seen the whole UK linker curve move from negative yields into positive territory.

This means that for practically any period of your choosing, you can now receive a guaranteed return above inflation, instead of paying for the benefit of owning that protection.

Again, given the current economic climate, this feels like an interesting trade for the long term investor.

You can see this in the following graph:

Don’t worry if talk about ‘curves’ and whatnot is a bit over your head.

The important point is that the green line – the YTM available after the sell-off in linkers – is above zero for all but the shortest duration index-linked gilts.

In contrast the yellow line shows that previously index-linked gilts were priced to deliver a negative return.

This shift (yellow to green) explains why your UK government bonds fell so far in 2022 and 2023.

But it’s also why longer-term returns should be much better now.

Capital gains and coupons

If you’re an active investor and you’re thinking about buying gilts for tactical reasons to exploit these shifts, you need to consider their return profile.

That’s because the way that capital gains tax on individual gilts works – there is none – means you might want to hold them outside of tax shelters.

This leaves more room in your ISAs and SIPP for your tax-liable stuff.

What’s more if you buy very short-term gilts, you could see a (tax-free) capital gain that is better than the (taxed) income you’d get with normal cash savings.

However if you struggle to fill your ISAs and SIPP, then you might skip the rest of this article. Buy your gilts inside tax shelters, where they are safe from income tax too, and fill your allowances!

Gilts versus gilt funds: Note that when I say gilts are capital gains tax-free, I’m referring to individual gilts. Gilt funds are a different matter – they are liable for capital gains tax – and index-linked gilt funds differ slightly again. See our article on how bonds and bond funds are taxed.

How you get paid when you invest in gilts

Remember there are two components to the return you earn from gilts.

The coupon

This is the fixed interest coupon the gilt pays every year. It varies by individual gilt issued.

For example ‘Treasury 0.125% 2039’ gilt will pay you 0.125% of its face value a year until 2039.

The redemption value

This is the amount you get back when a gilt is redeemed.

For example Treasury 0.125% 2039 has a par value of £100.

But as of October 2022, for example, Treasury 0.125% 2039 only cost £80 to buy.

Therefore if you bought this gilt and held it until 2039, you would make a £20 (25%) capital gain when it matured and was redeemed.

Note that prices are moving around a lot for gilts, so these prices may be long gone by the time you read this. Also spreads are wider than usual.

The important thing to grasp is there are two components to the return.

Combining the two: redemption yield, or yield-to-maturity

By far the most important yield to know about is the yield-to-maturity (YTM).

However the YTM is tricky to calculate, because it seeks to estimate your annualised return – taking into account both the coupon payments from the gilt and any capital return (or loss) on maturity.

Why is that so hard?

Think about it. I just told you that Treasury ‘0.125% 2039’ will be worth 25% more when it matures in 2039.

If you bought in 2022 and you could wait for 17 years then you were guaranteed to bank a profit.

However everybody in the gilt market also knows this. (My phone is not ringing off the hook as hedge funds beg me for more such secrets!)

We can therefore assume that the price will tend to move towards par value between now and 2039.

As we’ve been reminded in recent years though, the path towards par value won’t be smooth. Sometimes the gilt’s price will be up. Other times down. We can’t know exactly in advance.

Yet to do a YTM calculation, we – or a calculator – must make assumptions about reinvesting the coupon into a series of unknowable prices.

And that is what is difficult.

How to find out the yield-to-maturity (YTM) for a gilt

All that 99% of investors need to know is that the YTM provides the best guesstimate to the return you’ll get from a bond if you buy it today.

Moreover it’s not in the same category of finger-in-the-air guessing we do when we estimate future returns from equities. There’s solid maths behind the YTM calculation. Solid, but not 100% accurate, if that makes any sense.

But another snag is it’s hard to find yield-to-maturity quotes for free on the Net.

Retail sites typically quote coupons or running yields, which aren’t so helpful.

City pros use a Bloomberg.

However you can sign-up to download YTMs based on yesterday’s closing prices at TradeWeb. You need to register, but it’s free.

There’s no capital gains tax on individual gilts

At last we get to the much-trailed important bit about capital gains tax on gilts!

Remember, the yield-to-maturity is made of two components – the capital gain and income.

• For all investors, the capital gain portion is tax-free with gilts.

• Most investors will pay income tax on the coupon (outside tax shelters).

But here’s the cool bit…

Something that’s pretty clear in the name ‘Treasury 0.125% 2039’ is that the coupon is very small. It’s just 0.125%.

Moreover the interest you get from your coupon counts as savings income.

So savings income tax rates apply – including the starting rate for savings and the savings nil rate band.

This means you might not even be liable for income tax on the coupon, in some circumstances.

More usually though, the sort of person who buys individual gilts with their tax situation in mind will be paying income tax on savings.

Hence they will be interested in minimising the income coupon and maximising the tax-free capital gain.

How to pick gilts for fun and profit

In a nutshell: if you’re looking to buy and hold individual gilts to maturity, you want to pay attention to your tax situation – both now and in the future – before you decide which issues to buy.

We can assume all gilts have the same (extremely low) chance of default.

They’re all backed by the UK government, which can print its own money. It’s not like with other types of bonds or shares where you need to diversify.

So choosing a gilt based on the tax profile makes sense.

Compare and contrast

Everyone’s tax situation is different. But in general, higher and additional-rate taxpayers will want to look at short-dated gilts trading below par, with a low coupon but an attractive YTM.

This maximises the tax-free gains. The coupon is low, so not much return is lost to income tax. And the capital gain is tax-free.

You’ll also want to compare your after-tax YTM from gilts with that from cash savings, taking into account your particular circumstances.

Years ago you’d see suggestions as to which gilt would suit which bracket of taxpayers in print magazines.

Unfortunately though, I can’t point you to such a source today. (If anyone can, please let us know in the comments below.)

Note that if you sell your gilt before it matures for less than you paid for it – that is at a loss – you can’t set that loss against capital gains made elsewhere.

Individual gilts are outside the whole gains/losses merry-go-round from a capital gains tax perspective.

Gilts: down but not out

To recap, it has been an ugly spell for bonds of all types.

Inflation flared up, causing central banks to raise interest rates. That hammered bonds that had seemingly priced-in low rates forever.

The situation was made worse in the UK by the tumult around the Mini Budget and fears for the UK’s long-term finances.

We wrote on Monevator many times about the risks from government bonds trading at elevated levels, especially those of long duration.

For example:

• Why inflation-linked funds may not protect you from inflation (2016)
• How much will you lose if bond prices fall? (2020)
• Are bonds a good investment? (2021)

But that was mostly then – and this is definitely now.

Yes bonds could continue to chalk up dismal returns, in the short-term.

And while you can now get around 4% from a ten-year gilt – compared to 1% a few years ago – if high inflation sticks around for too long then the real return3 could still be disappointing.

So index-linked gilts seem to me an opportunity especially worth considering, given they offer a positive yield and inflation protection again.

Know what you’re buying into

Of course a measly 1% annual real return undoubtedly looks more attractive after a couple of years of rotten returns for UK bonds and shares.

Maybe shares will deliver 20% next year and you’ll regret piling into gilts for a 1% real return?

Maybe, but such speculation is for another day – and mostly another website.

The point is the return outlook for UK government bonds is brighter than it was. The pasting suffered by bond investors since the end of 2021 has made their prospects much brighter going forward.

Never dismiss an asset class just because it has had a spell in the dumpster.

And if you want to buy individual gilts, be sure to consider capital gains tax.

1. UK government bonds [↩]
2. Par is the face value of a bond. That is, the price the bond was issued at, which you get back when it matures and is redeemed. [↩]
3. That is, after inflation. [↩]