Gilt(y) Pleasures! | Luxury Finds Without the Guilt

Without planning, investment returns can be eroded by taxes. When investing, you always need to consider the tax implications and look at net-of-tax returns. Tax- advantaged wrappers can help with this (ISAs, LISAs, pensions etc), but sometimes the investment itself can be tax-efficient even without structuring. UK gilts are one such investment.

What is a gilt?

When the UK government wants to raise money, it issues bonds known as Treasury Stock. These were historically issued in certificated form with gilded (gold coloured) edges, leading to them being known as gilt-edged securities, or simply ‘gilts’.

Gilts are issued for a fixed period of time and pay interest every six months, based on a fixed rate of interest. For example, the Treasury 1.625% 22 October 2028 bonds which were issued periodically since 2018, will mature automatically on 22 October 2028, and pay an interest coupon of 1.625% per year – payable at one-half every six months.

Taxation of gilts

Gilts are taxed as follows:

• interest coupons – taxable as income at the time of payment; and

• capital gains on sale of bonds – tax exempt.

In addition, when bonds are purchased or sold, part of the consideration represents a payment for the interest accrued on the bond up to the date of the purchase or sale. Under the accrued income scheme (AIS), any accrued interest received on a sale is taxable as income, and any accrued interest paid for on acquisition can be offset against the next interest payment date (NB: there is an exemption from the AIS where interest-bearing securities of less than £5,000 are held).

Buying and selling gilts

Gilts can be bought and sold on the London Stock Exchange at a price determined by the market. The price fluctuates based on the prevailing interest rates and the length of time left to maturity. For example, the October 2028 bond mentioned above is trading at around 95p at the time of writing. This is because the current prevailing interest rates are higher than 1.625% and there are over two years left until maturity.

Returns on gilts

The fluctuation in the price of gilts and the exemption from tax on capital gains gives an interesting opportunity; if you purchased 10,000 of the 2028 bonds at 95p, it would cost £9,500. When the bonds mature at £10,000, a £500 capital gain would be realised. There would be no tax on that gain. In addition, interest at 1.25% would be received for a period of around 2.5 years, giving further income of around £425.

This is liable to tax, so a 40% taxpayer would pay £170 of income tax. After tax, the £9,500 investment has generated £500 of tax-free capital gain, and £255 of net interest, giving a net-of-tax return of £755. Over a period of 2.5 years, that is the equivalent of 3.18% net return.

A 40% taxpayer would need to secure an interest rate of 5.3% gross to achieve the same net return (5.62% for a 45% taxpayer), much higher than rates available on two-year bonds at the time of writing (approximately 4.2%). If the interest was covered by the £1,000 or £500 personal savings allowance, the equivalent gross returns would be higher still.

Conclusion

Any investment decisions should be taken with advice from your financial adviser, but remember to discuss gilts and assess whether the CGT exemption can be utilised to provide enhanced returns on cash savings.

Practical tip

For individuals with cash outside of tax- advantaged wrappers, an investment in gilts can provide a superior net-of-tax return due to the exemption from CGT on the unwinding discount. The return can be accurately predicted, provided the gilts are held to maturity.