How a gilt ladder could be your next income strategy

• Gilts are exempt from capital gains tax, creating a potential benefit for investors who buy gilts at a discounted price and hold until maturity
• Gilt ladders are helpful for planning a specific stream of returns to match specific outgoings
• Investors can build their own gilt ladder through choosing bonds with different maturity dates
• This strategy requires a good understanding of how bonds work

What are gilt ladders?

A gilt ladder is a way of building a portfolio of different UK government bonds whose maturities coincide with future spending needs. The investor purchases a variety of individual gilts with different maturity dates. This creates the ‘ladder’ effect, as investors receive a steady stream of payouts as the gilts reach maturity and the original debt is repaid. Some investors who create gilt ladders will also aim to buy the gilts below their issue price so they a capital gain once the bonds are redeemed. 

Learn more about gilts

Why create a gilt ladder?

Much of the appeal of gilt ladders comes from their tax advantages. While investors must pay income tax on the interest received from gilts, they are exempt from capital gains tax. This means that if you buy a gilt at a discount to its original price, the difference between the purchase price and the face value, known as the capital gain, will be tax-free when the gilt matures.

This can be complicated, so we’ll break it down with an example: Let’s say an investor, John, is looking to buy a gilt, and finds one that was issued when interest rates were low and which expires in January 2028. The coupon (the amount paid in interest on the gilt) is 0.125%. It was issued at £100 and is now selling for £93.

Why are you able to buy gilts on a discount? 

It may seem strange that you are able to purchase a gilt for less than you’ll receive back in a few years' time, but it’s all about the pricing on the wider market. Gilt coupons are largely dependent on interest rates at the time when they are issued. But because interest rates change frequently, it means you end up with bonds that have a variety of coupon rates.

When these gilts are traded on the market, gilts with higher coupons tend to be in demand. So, to keep their appeal, gilts with lower coupons will trade at a price that is below what they were originally issued for, for example, £93 instead of £100. This might seem like an easy win, but remember, you’re also fighting inflation, which can dampen real returns.

John buys the gilt and receives his coupon payments every six months until the bond matures. In January 2028, he is repaid the original face value of the gilt of £100. Because he bought it for £93, the £7 difference is the capital gain on his investment. There is no capital gains tax to pay on this portion of the return.

When someone builds a gilt ladder, they look for bonds that will produce returns at different periods. For example, you may purchase gilts maturing in three, five, six, seven and eight years to build the structure. This creates a roadmap for exactly when you will receive income payments and a lump sum when the bond matures. That can be helpful if you are trying to plan for specific outgoings at certain points in the future, such as education fees for your children.

What tax will you face for investing in gilts?

If you hold your gilts inside an ISA, you won’t face any income tax or capital gains tax on your gilt ladder. But because ISA contributions are capped at £20,000 a year for a Stocks and shares ISA, this is sometimes not enough leeway to build your gilt ladder.

If your coupon payments exceed your annual income tax allowance and the gilts are held outside an ISA, pension, or other tax-free wrapper, you will face income tax on your investments at your income tax rate, which is 20% for basic rate taxpayers, 40% for higher rate taxpayers, and 45% for additional rate taxpayers.

Gilts are exempt from capital gains tax which makes the concept of a gilt ladder appealing to someone who has used up their annual ISA allowance. Note that gilt funds or bond funds holding gilts do not qualify for the capital gains tax exemption.

How to build a gilt ladder

Gilt ladders take a bit of effort to set up, but once they are in place, are straightforward to manage as the investment is typically held until maturity rather than trying to time the market. Individual gilts can be bought and sold online via AJ Bell’s website.

Here’s a few steps to start your ladder

1. Create a list of major outgoings, such as education fees or interest-only mortgage reaching the end of its term.
2. Explore the range of gilts available to buy in the market and see which ones mature to coincide with outgoings on your list.
3. Investors building a gilt ladder typically seek bonds that trade below 100, which is generally the face value price. Buying for less than 100 means you would make a capital gain if held to maturity. Note that buying above 100 would imply a capital loss.
4. Here’s what a gilt ladder might look like once completed, using hypothetical examples. It is purely for illustrative purposes and not investment advice.

The table illustrates how capital gains account for the bulk of the returns, underpinning why the gilt ladder might appeal to someone seeking to take advantage of no capital gains tax to pay on UK government bonds.

It is important to keep track of the income portion as there may be tax to pay if the gilts are held outside of an ISA or SIPP, once your annual allowance is used up.

Where to find gilts

You can find a list of tradeable gilts on the AJ Bell website. If you are looking for gilts that trade on a discount, the best way to assess this is through the price. Many gilts will be trading somewhere between £80 (a discount) and £101 (a slight premium). But you’ll find some outliers as well. It’s important to make sure any bond selection will be able to meet your needs as an investor. For example, are the coupon payments enough to sustain your ladder plan, or are you happy to just wait for the larger payout when the bond comes to maturity? You’ll also want to ensure that the bonds you purchase are fitting your timeline, so it may help to search first by date, and then focus on the bonds that appeal to you during that time period.   

Buying individual gilts requires a good level of investing experience and understanding of bond prices. It’s not for everyone, and anyone less experienced who is considering going down this route may want to speak with a financial adviser before doing so.