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Capital gains tax on gilts

An image of pound coins to illustrate keeping more of your capital gains on gilts

A strange time to talk about capital gains tax on gilts. In the midst of a year in which they’ve delivered historic losses!

I imagine you’ve seen the headlines. How gilt1 prices cratered in the wake of the Mini Budget. How the Bank of England tried to smooth things over.

Gilts have now fallen so sharply that their expected return profile has changed dramatically.

Going into 2022, gilts were trading well over par.2 Investors hungry for yield had bid up gilt prices for a decade.

A capital loss was guaranteed, sooner or later. That was 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, the vast majority of 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 I’m seeing lots of readers talking about dumping their UK government bonds.

Even passive investors!

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

But now, after a truly dire year for government bonds, some seem ready to throw in the towel.

However before you do anything it’s important to understand the reversal in gilts’ prospects.

As I write, even index-linked gilts are sporting a small but positive yield-to-maturity (YTM).

Yes, you can now guarantee a return over 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, because the funds hold a rolling stock of gilts.

But 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, not least given the political turbulence in the UK.

But the important thing is not to judge UK government bonds by what they’ve done recently. But rather by what they’re priced to potentially do now.

Nice curves

Here’s what at M&G Investments’ pros – the self-styled Bond Vigilantes – have to say about it today:

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 now – is above zero for all but the very shortest duration index-linked gilts.

In contrast the yellow line shows that just one month ago index-linked gilts were priced to deliver a negative return.

This shift is why your existing UK government bonds are in the red. But it’s also why returns should be much better from here.

Capital gains and coupons

What’s more, if you’re an active investor and you’re thinking about buying gilts for tactical reasons to take advantage of these shifts, then you need to think a bit more about their return profile.

The way that capital gains tax on individual gilts works – there’s none, in short – means you might want to hold them outside of tax shelters. That way you leave more room in there for your tax-liable stuff.

If however you struggle to fill your ISAs and SIPPS, then you can skip the rest of this article. (Just buy your gilts inside tax shelters, where they are safe from income tax too.)

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.

Remember there are two components to the return 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. As I write it only costs £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 at present, so these prices may be long gone by the time you read this. Also spreads are wider than usual.

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

By far the most important yield we need to worry about is the yield-to-maturity (or YTM).

This 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 difficult?

Well, think about it. I just told you that Treasury ‘0.125% 2039’ is going to be worth 25% more when it matures in 2039.

If you can wait for 17 years then you’re guaranteed to bank a profit.

However everyone in the gilt market knows this. (My phone is not ringing off the hook as hedge funds ply me for more secrets.)

We can therefore assume that the price will – more ‘shock and poor’ volatility aside – tend to move towards par value between now and 2039.

We’ve seen this year that the path towards par value won’t be smooth.

Sometimes the gilt’s price will be up, other times down. We can’t know how exactly in advance.

But to do a YTM calculation, we – or in practice a calculator – have to make assumptions about reinvesting the coupon into this series of unknowable prices.

Which is tricky.

All 99% of investors need to know though 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 guesswork we’re forced to do when we estimate future returns from equities, say. There’s solid maths behind the YTM calculation. Solid, but not 100% accurate, if that makes any sense.

The other snag is it’s hard to find yield-to-maturity quotes for free on the Web.

City pros use a Bloomberg. Retail sites quote coupons or running yields, which aren’t so helpful.

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 be liable to pay income tax on the coupon (outsider of tax shelters).

Now 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. Which means savings income tax rates apply – including the starting rate for savings and the savings nil rate band.

Perhaps you won’t 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 pay income tax on savings.

So they will be interested in minimizing the income coupon and maximizing the tax-free capital gain.

How to pick gilts for fun and profit

In a sentence: 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.

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

This maximizes the tax-free gains. The coupon is low, so not much return is lost to income tax.

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

Incidentally years ago you’d see suggestions as to which gilt would suit which bracket of taxpayers in print magazines. Possibly even the weekend newspapers, unless my memory is playing tricks.

Unfortunately though, I can’t point you to such a source today. (If anyone has a lead, 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 you make 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 a very ugly year for bonds of all types.

Inflation has persisted, causing central banks to raise interest rates. That’s hammered bonds that were seemingly priced for 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:

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

For sure bonds could continue to chalk up dismal returns, in the short-term especially.

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

Index-linked gilts do seem to me an opportunity worth grasping, given they are now offering a positive yield and inflation protection again.

But of course a 1% annual return only looks especially attractive because in 2022 everything has turned south.

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

But such speculation is for another day, and mostly for another website.

The point is the return outlook for UK government bonds looks much brighter. Even as investors in the asset class peel themselves off the floor from the pasting they’ve had in 2022!

Never dismiss an asset class simply based on what it’s done for you lately.

And if you want to mess about with individual gilts, 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. []
{ 23 comments… add one }
  • 1 The Rhino October 14, 2022, 12:56 pm

    Had been pondering just this earlier today. So much so that I looked up an old 2010 monevator article on the subject.. Gilt funds, ETFs etc. Are liable for CGT though right? (As per bullet point in article mentioned) sorry I should link to that article but it’s being me when typing this from my phone

  • 2 The Investor October 14, 2022, 1:07 pm

    @The Rhino — Yes, I should make that clearer. Here’s the article you want:

    https://monevator.com/bonds-and-bond-funds-taxed

  • 3 Vroom October 14, 2022, 2:51 pm

    I’ve been buying these in the last few weeks, after a tip in a comment thread here (@SeekingFire?). As you say, it’s a lot harder pricing them without Bloomberg etc. Some things I’ve learnt (or relearnt after 10-12 years since I last traded them):

    • There’s an ‘LSE feed’ of prices for retail clients in Gilts. This is inside the wide Bid-Offer you see on the initial HL or ii page, to get to it you just ask for a quote as you would with any share or ETF. It’s seems to be the same feed for all of the retail brokers, a composite of the (wide bid-offer) interests of the market-makers
    • These prices do bang about intraday, especially recently with the volatility. If you look e.g. at IG for prices in forward starting SONIA (roughly base rate, in the months ahead) and the Gilt, you can see/follow when short and long Gilts are being offered down or bid back up. Looking on IG or elsewhere at the Gilts ETFs and Index-Linked ETFs gives further colour
    • Now and then you suddenly get really good offers, especially in sell-offs. Presumably this is market-makers showing a keener interest to the LSE feed
    • Nevertheless the Bid-offer is a lot wider than shares/ETF’s so not something to be trading in and out of as retail, more a buy and hold investment
    • Excel has a Yield function which calculates the YTM of Bonds. Type =YIELD(maturity date,2 working ways date,coupon,price,100,2,3) for £ bonds
    • So for the TN24 I’ve been buying, 0.125% coupon expires 31st Jan 24, today is Friday 14th oct so 2 working days is 18th Oct, Offer price is 95.86, you’d type =YIELD(31/1/24,14/10/22,0.125,95.86,2,3) giving you an answer of 3.44% currently (was 4.25% ish last week).
    • You can check those yields e.g. on Interactive Brokers, though there’s not much liquidity there

  • 4 Vroom October 14, 2022, 3:01 pm

    I also bought a couple of Linkers (TR26 and T28) on Wednesday morning in the panic sell-off, though only in small (not enough with hindsight…). Fair to say that’s a bit more involved again…

  • 5 Neverland October 14, 2022, 3:50 pm

    “But in general, higher and additional-rate taxpayers might want to look at short-dated gilts trading below par with a low coupon but an attractive YTM.”

    I don’t think that exists right now because of short term inflation expectations; but maybe we’ll have a new conservative leadership contest before the end of the month so who knows?

  • 6 Always Late October 14, 2022, 6:05 pm

    On the 25th November, 2020, the Chancellor of the Exchequer announced that index-linked gilts will no longer be linked to the Retail Price Index (RPI), but the newer Consumer Price Index including housing costs (CPIH). This switch will take place from 2030 and will save the government an estimated £2 billion a year. Holders of index-linked gilts will receive no compensation.

  • 7 Mousecatcher007 October 14, 2022, 6:13 pm

    Thank you. Really interesting.

  • 8 Mr Optimistic October 14, 2022, 6:39 pm

    Good article. Finding real returns on IL gilts has alluded me. Plus halifax on line require you to deal over the phone and as you say spreads are a bit wild. I hold IL 2.5% 2024 which went from a cumulative gain over the years of 60% to 64% in a day.
    Did you mention about clean and dirty prices and how the dirty price for an IL gilt includes the inflation uplift ? Tnink I have that right.

  • 9 Vroom October 14, 2022, 6:43 pm

    @Neverland – The TN24 Gilt I bought last week (0.125%, ends in just over 15 months) had a YTM of 4.25%. 0.125% of that will be the 2 remaining coupons, subject to Income tax. The rest of the 4.25%/year will be in capital gains, so tax free in this case. If you’re paying tax at 40% you’d need roughly 4.125%/0.6 = 6.87% on your savings to beat it (outside of a tax shelter like an ISA). Plus it’s “instant access” – you can sell the Gilt and get your funds back whenever you want (though you would have to cross another spread and accept the then current rate for good or ill). Not better than today’s inflation, but *might* be better than the inflation between now and when it ends. Definitely better than any cash alternatives.

    If your view is that RPI is going to stay at these kind of 10%+ levels you should but one of the low coupon linkers TI referred to. To the best of my understanding without Bloomberg etc (hides under table if someone like @ZX reads this) the TR26 (0.125%, ends 22/3/26) I bought not enough of had a real yield of 0.47% versus an equivalent nominal (normal Gilt) yield of about 4.45%. So the inflation ‘breakeven’ here is 4.45% – 0.47% = 3.98%. That means if RPI between now and 22/3/26 is that 3.98%/year you’ll get the nominal yield of 4.45%. If say RPI turns out to be say 4.98%/year (1% more than the breakeven when you bought it), you’ll get the extra 1%, so a return of 5.45%/year. & so on – big returns if inflation stays around 10% and you hold to maturity (be aware that the price of linkers can move hugely in the interim, so for retail investors a buy and hold strategy is often best, leave the long dated stuff for the traders)

    The T28 (0.125%, ends 10/8/28) has better terms, nominal yield 4.51% ish, real yield 1.04% so breakeven 3.47%. But there’s longer for inflation to go down and you’ve got to be prepared to hold it for nearly 6 years. Nevertheless, as TI said these real yields have been negative for most of the last 20 years, so a new opportunity, silver linings and all that.

    Also makes it more likely we get NS&I granny bonds back imho, as these are no longer “more expensive” for the DMO to issue..

  • 10 Vroom October 14, 2022, 6:50 pm

    @ Mr Optimistic – that simple Excel formula also works for the Real Yields of Linkers (using the clean price which is what the screens show and what they quote you)
    https://www.bogleheads.org/forum/viewtopic.php?t=170993

    As you say, the dirty price includes a big chunk of inflation uplift. For us retail types I haven’t found a better solution than just comparing yesterday’s clean and dirty prices from Tradeweb and adjusting the current clean price accordingly.

  • 11 DJ Bond October 14, 2022, 6:56 pm

    As ever, thank you for the wonderfully helpful article.
    Two questions for author / readers:
    – With a gilts ETF say (iShares UK Gilts 0-5yr UCITS ETF | IGLS) how do I work out what are my capital gains vs income? Id usually assume the difference in what I buy / sell the ETF for are my capital gains / losses. But Im wondering if there’s more to it than that?
    – Thank you for the heads up on Tradeweb; that sounds very helpful. iShares seems to report an overnight weighted average YTM but Id like to double check! Where on Tradeweb do I search for gilts / bonds ETFs? Ive had a dig but no luck
    Thank you.

  • 12 Norman October 14, 2022, 7:33 pm

    Is anything likely to drastically reverse gilt yields in the short term? I’m looking into constructing a gilt ladder but it would involve transferring my SIPP elsewhere. I can only see yields increasing further but would be interested in the thoughts of the wiser.

  • 13 Seeking Fire October 14, 2022, 9:19 pm

    Good article and good comments – Vroom etc.

    I agree Gilts are kind of looking quite interesting again, although it’s also very notable that other assets are looking very interesting too – PHP LN on a 6.7% divi yield anyone…..

    I also bought the TN24 to hedge a liability coming up. Gilts are very useful from that perspective. You need to find x amount at a set point in the future, find the closest Gilt and then work back to what you need to put aside today. Similar to a bond ladder for retirees or savers etc.

    On index linked gilts, particular the long duration, it’s worth being aware that although they are now showing a +ve real yield, it’s perfectly feasible that real yield increases substantially from here. Not such an issue for short dated bonds obviously. No prediction – I have no clue.

    Take the 2073 ILG and check out the price chart over the last month. It’s not for the faint hearted, widows or orphans. Having said that, if the price fell back to 40 or below then that feels very good value.

    https://www.hl.co.uk/shares/shares-search-results/t/treasury-0.125-22032073-index-linked-gil

    A good example of a bond showing much more volatility than an equity. Which is the opposite of what the uninitiated would think.

    I agree unless you are trading, holding individual bonds to maturity makes a lot of sense.

    Nice to see the bond market dictating economic policy from here on not the treasury 🙂

  • 14 Andrew October 15, 2022, 1:17 am

    The estimated redemption payments (based on some entered average inflation rate) can generated on the DMO’s website:

    https://www.dmo.gov.uk/data/pdfdatareport?reportCode=D9C

    e.g. for the 2073 bond, which last traded at £77.97 according to H&L and currently reports £496.99 on the DMO report

    =YIELD(“18/10/2022″,”22/03/2073”,0.125/100,77.97,496.99,2,3) = 3.78%

    I would guess this is slightly more accurate than just compounding £100 over 50 years at 3%? Perhaps it takes in to account the inflation indexing on the coupons as well?

  • 15 Andrew October 15, 2022, 1:32 am

    Actually I guess it would make more sense if these DMO estimated redemption payments are taking in account indexation that has already passed since issue?

    I suppose accounting for indexation of the coupons is much more tricky and would just be a bonus

  • 16 Mr Optimistic October 15, 2022, 8:32 am

    @Vroom. Thank you.

  • 17 Naeclue October 15, 2022, 11:21 am

    @Vroom “Excel has a Yield function which calculates the YTM of Bonds. Type =YIELD(maturity date,2 working ways date,coupon,price,100,2,3) for £ bonds”.

    Small point, but you should use 1 as the day count basis instead of 3. 1 is actual/actual, 3 is actual/365. Gilts used to trade actual/365 but that changed over 20 years ago.

  • 18 Naeclue October 15, 2022, 11:35 am

    One other point worth mentioning with respect to tax on gilt interest is the handling of accrued interest. When you buy a gilt you pay accrued interest (usually). You can deduct that accrued interest from other interest payable in the tax year. Don’t forget to do that!

    Similarly you must include in your tax return any accrued interest paid on the disposal of a gilt, or other bond.

    You will find the accrued interest on the contract note.

  • 19 Hospitaller October 15, 2022, 12:10 pm

    Useful article. I have been buying straight gilts and hedged US treasuries as yields rose. Primary reason was that I came into investing in the QE years when relevant yields were so low and I always wanted the ballast in the portfolio but not at those rates. Now is very different. Also, while I do not expect rates to drop back to as low as they were, I do not expect us to be looking at 4.76 ytm on 30 year gilts in the medium term and so there may be some profit out there too.

  • 20 Vroom October 15, 2022, 2:08 pm

    @ Naeclue – thanks, showing my age there!

  • 21 Naeclue October 15, 2022, 6:17 pm

    @Vroom, your welcome!

    Incidentally, I have just spotted that you have also swapped the maturity and settlement dates round when you typed in your formula. It should be
    =YIELD(settlement date, maturity date,coupon,price,100,2,1)

    Hopefully that has not confused anyone!

  • 22 Naeclue October 15, 2022, 6:53 pm

    @Andrew, As Vroom has said, you can use the YIELD() function to calculate the real yield of an index linked gilt. You just plug in the clean values for coupon and 100 for the par value. ie you ignore the Index Ratio. This works because both the current price, redemption price and coupons are all uplifted by the Index Ratio and so fall out of the calculation. That is not totally accurate, but would certainly be ok to 2 decimal places for normal IL real yields and inflation figures.

    If you want to know the nominal yield on some speculative rate of inflation, just add the real yield, as produced by YIELD() to the inflation. Again, not totally accurate, but good enough.

    To get a more precise figure, layout all the future speculative inflation adjusted cashflows in a spreadsheet and calculate the internal rate of return using XIRR(). You do have to include the purchase price+accrued (as a negative number) and the inflation adjusted redemption price.

    By the way, I think that DMO page you linked to just calculates the future redemption price of an index linked gilt based on the speculative rate of inflation you enter. It does not take the coupon payments into consideration.

  • 23 Valiant October 16, 2022, 12:39 pm

    Thanks for this. I remain baffled by Gilts. May I ask if anyone can link to more discussion of these two points specifically (I’m trying to follow a Kriojer-style passive strategy):

    1. Exactly *which* Gilt ETF is appropriate in which case? I did have some VGOV, which I think has average maturity 14 years; and have some IGLS which I think is 1-5 years. Orthodoxy states hold Gilts which match your investment horizon but I am in retirement drawdown already, am 60, and need to provide for perhaps 30 years. I find it difficult to map the advice to my circumstances.

    2. Further explanation of The Monevator’s fascinating article last week of why a Gilt fund may have had big losses recently, but this will eventually lead to big gains. I don’t get it. I understand that increasing yields mean that anyone buying new gilts will get better returns because of the increased yields, but surely *I* won’t, because I still own the crappy old ones? I didn’t quite follow the explanation.

    Thanks for reading!
    V

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