In the middle of a bull market in stocks, gilts are back on the menu for investors. They might not offer the eye-popping returns experienced by Nvidia (NVDA:NASDAQ) shareholders, but nonetheless individual gilts were some of the most popular investments made over the last year on the AJ Bell platform, both by financial advisers and DIY investors.

Clearly rising interest rates have precipitated gilt yields which are much more appealing. The tax treatment of gilts has also fuelled their popularity. Investors aren’t liable to capital gains tax on gilts, so if you can find a gilt where a lot of the yield is coming from capital returns rather than interest, you can save on your tax bill.

This is where we have seen a lot of activity in the gilt market, with short-dated, low coupon gilts being effectively used as a tax-efficient cash alternative. This has led to big savings for higher rate and additional rate taxpayers, some of whom have picked up bonds where the equivalent taxable cash account would need to be paying interest of 7% or more to match the yield after tax. There is likely to be some continued appetite for using gilts as tax-efficient, safe cash alternatives for a rainy-day fund, especially in light of frozen income tax bands. But gilts can be used for other purposes too.

USING GILTS TO MEET FIXED FINANCIAL GOALS

Individual gilts have a specific maturity date, and so can be useful for investors who have a financial goal which comes with a set time by which it needs to be achieved. An example might be investing for a university fund, or for a tax-free cash lump sum to be taken at retirement. In this way they act a little like fixed term cash accounts, except some of the returns from gilts may be tax-free because they are capital gains, not income. Gilts are also available at longer maturities than fixed term cash accounts for those who have a more distant financial goal and want to lock in a set interest rate.

Low coupon gilts are still available across the maturity spectrum, for those who wish to reduce their tax bill by locking in capital gains rather than income, because they are investing outside a SIPP or an ISA (see table below). The longer dated the bond that you buy, the greater volatility it can be expected to exhibit though, and the more sensitive to interest rate movements it will be. Cashing in early could therefore create a more substantial loss if interest rate expectations have moved up since your purchase. Longer dated bonds with low coupons also have lower prices, and so the actual income yielded per £100 of investment will tend to be higher, and therefore attract more income tax.

USING GILTS AS AN ANNUITY ALTERNATIVE

Buying higher coupon gilts in a SIPP drawdown account, or in an ISA, might be considered as an income strategy by those in retirement, as it’s similar to what an insurance company does to provide you with an annuity income. The difference is the annuity company also takes control of your capital, which it also pays back to you over time, hence why the annuity rate will be higher than gilt yields alone. An annuity also pays out for your entire life, even if you live to over 120. A gilt held in a SIPP drawdown account wouldn’t necessarily do that, and so this approach could mean you run out of money before you die.

However, you have much greater flexibility over gilts held in a SIPP drawdown account rather than an annuity. You can hold gilts alongside equities and funds, to produce a diversified stream of income with the potential for capital and income growth. You can also dictate when the capital is run down, perhaps leaving it untouched to begin with if you don’t need the boost to your income immediately. You can also dictate when the interest is withdrawn from the pension account so you minimise the tax payable; an annuity is paid regularly and there is no way to hold back payment in one year if you’re facing a large tax bill. Annuities are pretty valuable if you happen to live to a ripe old age, but not if you die young, in which case your pot disappears (unless you paid upfront for a spouse’s pension or a guarantee period). With gilts held as part of a SIPP drawdown portfolio, if you die before the fund is extinguished, the remainder can be passed onto beneficiaries, after tax.

USING GILTS TO DIVERSIFY

Gilts can of course also be used as diversifiers for an equity portfolio, and the lenient tax treatment can be helpful for those investing outside a SIPP or ISA wrapper in lieu of bond funds, which pay a taxable interest payment. Bond prices often move in the opposite direction to the stock market, so holding them in a portfolio can dampen volatility. It also means all your eggs aren’t in one asset class bucket.

There was a huge cost to diversifying using gilts when interest rates were low, because yields were close to zero and investors had to accept below inflation returns from this side of their portfolio. As a result, many turned to other sources of diversification such as gold, property, infrastructure and absolute return funds. With yields back at more ‘normal’ levels, investors can now comfortably use gilts to hedge against stock market movements, while picking up a reasonable return from these bonds.

DISCLAIMER: Financial services company AJ Bell referenced in this article owns Shares magazine. The author (Laith Khalaf) and editor (Tom Sieber) of this article own shares in AJ Bell.

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