What to do about rising bond yields – making the case for gilts

Gilt yields have broken out to multi-year highs, with the 10yr above 5.23%, the highest its been since the financial crisis, while the yield on the 30yr gilt has not been this high since the 90s.

For investors this has important implications for where to put your money – we can look at the degree to which higher bond yields affect stocks in a separate feature (not least the fact that the FTSE 100’s recent rally has seen its dividend yield decline to around 3%). For now, let’s look at gilts.

If you buy gilts directly (rather than say via a gilt ETF or fund) buying now means locking in the higher yield on offer that is the result of the recent turmoil in bond markets.

Take for example TN28 – ⅛% Treasury Gilt 2028. Maturity: 31 January 2028. Coupon: 0.125% per annum. Price: approximately £94.60 per £100 nominal.

Capital uplift if held to maturity

An investor purchasing at £94.60 and holding until January 2028 will receive £100 at maturity.

• Capital gain: approximately £5.40 per £100

• Capital return: approximately 5.7% of the purchase price

The capital uplift is the primary source of return. This means there is only capital gains tax to pay on the nominal coupon. Lots of investors have been drawn to these low-coupon, short-dated gilts for this reason.  

These pay a lower rate of fixed interest, but as the bond moves closer to its maturity date its price moves up towards its nominal value. In effect this results in a higher after-tax yield for compared to higher-coupon gilts.

The effect is bigger in a higher yield environment when lower-coupon gilts are trading at a lower value, increasing the capital gain at maturity.

Yield may compare favourably with cash after tax

Many investors focus on the 0.125% coupon and assume the bond offers almost no return.

However, because the bond is purchased below par, much of the expected return comes from the capital gain rather than income, so the return is more like 5.7%. the annual return (or mid-yield to maturity) is around 4.1%.

For UK taxpayers:

• Gilt coupons are taxable as income.

• Capital gains on UK gilts are generally exempt from Capital Gains Tax.

The low coupon and higher capital uplift can therefore be tax-efficient relative to some cash savings products.

Low default risk

Conventional gilts are backed by the UK government and are generally regarded as among the lowest credit-risk sterling investments available. For investors seeking capital preservation over a relatively short period, the credit risk is minimal compared with corporate bonds.

Limited interest-rate sensitivity

With less than 18 months remaining until maturity, TN28's duration is quite short.

This means:

• Smaller price swings than long-dated gilts.

• Less exposure to future Bank of England rate surprises.

• More predictable returns if held to redemption.

Known maturity value

Assuming the UK government honours its obligations, an investor knows they will receive £100 at maturity regardless of interim market movements. This can be attractive for investors with a specific liability due in early 2028, such as a tax bill.

Opportunity cost

The major risk seems to be in the opportunity cost of holding the cash-like instrument, versus say investing in riskier assets such as equities, which could deliver a larger return. They could also drop in value. In a world of AI bubble risks and central banks being forced to tame inflation a la 2022, it's clear why some investors might prefer to lock in a steady, known rate of return.