Investor Insights: Gilts or gilt funds – pros and cons of differing approaches to fixed income investing

UK government bonds – gilts – have come back into focus as yields climbed off the back of a surge inflation. This dynamic is changing as inflation cools and the Bank of England cuts rates, with further downward adjustments expected this year. For retail investors, gilts now offer a mix of income, capital-gain potential and unique tax advantages. Here’s how to access them, and what to watch.

What are gilts?

Gilts are bonds issued by the UK Debt Management Office on behalf of the British government. When you buy a gilt, you are lending money to the government in return for:

• Regular interest payments (the coupon)

• Repayment of face value at maturity

Because they are backed by the UK government, gilts are considered among the lowest-credit-risk assets available to UK investors. The British government has never defaulted on its obligations.

Types of gilts available

Conventional gilts

These pay a fixed coupon (e.g. 4% annually) and return £100 face value at maturity. Prices move inversely to interest rates. These are generally best for income-focused investors, especially those who have a view on where rates are heading.

Index-linked gilts

Coupons and principal are linked to inflation (RPI), providing inflation protection. However, prices can be volatile and long-dated linkers are highly sensitive to real yield moves. These are generally seen as best for inflation hedging by long-term investors comfortable with price swings.

Tax treatment – a major attraction

This is where gilts stand out for UK retail investors.

Capital gains: tax-free

• Gilts are exempt from UK capital gains tax

• This makes low-coupon or “deep discount” gilts particularly attractive

• If held to maturity, any price uplift is CGT-free

Income tax: coupon is taxable

• Coupon payments are treated as interest income

• Taxed at your marginal rate (20%, 40% or 45%)

• Can be sheltered inside an ISA or SIPP

Low vs High Coupons

Traditionally the market for retail investors has been concentrated in the ultra-short end. For reference ultra-short: less than 3 years, short: 3–7 years, medium: 7–20 years, and long: greater than 20 years.

Many higher-rate taxpayers favour low-coupon gilts where most of the return comes from tax-free capital appreciation as the gilts approach maturity rather than taxable income.

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 - such as the 2022-2024 period -when lower-coupon gilts are trading at a lower value, increasing the capital gain at maturity.

Things may be changing though. In a lower yield environment where the effect is less pronounced, it makes sense that investors are looking at higher coupons once again, particularly if they can include these within an ISA tax wrapper, since holding gilts within the ISA tax-free wrapper offers complete tax exemption on both interest and capital gains. Indeed, retail holdings of middle and high-coupon gilts have risen over the past three years, says the BoE, which could be down in part to the income tax exemption gained from holding gilts in an ISA or SIPP.

Ways to invest in gilts

1. Buy individual gilts directly

Due to the tax treatment of gilts, many investors look at low-coupon gilts that generate most of their return through the capital appreciation as they approach maturity.

Available low-coupon, short-maturity gilts include the United Kingdom 0.125% 31 Jan 2028, which matures in two years. Another is the United Kingdom 0.25% 31 Jan 2031, which has five years left before it matures.

But if you prefer a higher coupon – say within an ISA tax wrapper rather than capital appreciation - the United Kingdom 4.125% 29 Jan 2027 currently trades slight above par at £100.44.

Pros

• Full control over maturity and cash-flow timing

• CGT-free capital return if held to maturity

• No ongoing fund charges

Cons

• Requires more effort to select issues

• Less diversification unless buying multiple gilts

Best for:

Investors building a bond ladder or matching future liabilities, such as for school fees.

2. Gilt ETFs

ETFs provide diversified exposure and daily liquidity.

Common examples offering exposure across various maturitiesinclude the Vanguard UK Gilt UCITS ETF and the iShares Core UK Gilts UCITS ETF.

Different durations can be selected. The iShares UK Gilts 0-5 Yr GBP (Dist) UCITS offers exposure to short-duration bonds, while the Invesco UK GILT 15+ Year UCITS ETF, as the name suggests, focuses on longer-duration maturities.

As well as short-duration, long-duration and all-maturities versions, these can come as index-linked variants such as the iShares GBP Index-Linked Gilts UCITS ETF.

Some investors may like to look at the iShares Core Global Aggregate Bond ETF GBP Hedged (AGBP). This tracks the Bloomberg Global Aggregate Bond index and has about 20k holdings and charges of a fee of 0.1%. UK investors mayhowever prefer to go with an ETF that has a stronger weighting to gilts.

Pros

• Instant diversification

• Easy to trade

• Suitable for smaller portfolios

Cons

• Ongoing charges

• No defined maturity (price risk never disappears)

• Income is fully taxable unless held in ISA/SIPP

Gilt funds tend to own a mix of maturity, which can mean they are more sensitive to interest rates than an individual gilt close to maturity. Funds therefore can be a useful vehicle for bonds if rates are declining, but less reliable if rates are climbing. This is perhaps best for tactical allocation or investors who prefer simplicity.

3. Bond funds

Actively managed funds can tilt duration or maturity exposure. Bond funds do not mature, so capital is always exposed to interest-rate risk.

Strategic bond funds invest across the fixed income space, looking at bond types, duration, sectors and credit risk. There are risks even if with perceived ‘safe’ assets such as bonds. For instance, managers may be inclined to boost returns by increasing duration or credit risk, which can catch them out in a sharply rising rate environment, as occurred in 2022. These are usually considered more complex products.

Where gilts fit in a portfolio

Gilts can play several roles:

• Income generation at higher yields than seen in the last decade

• Diversifier versus equities during growth slowdowns

• Capital-gain opportunity if rates fall

• Tax-efficient return for higher-rate taxpayers

They are not risk-free: the value of any investment can go down as well as up. We are entering a time in which fiscal credibility is being questioned across the developed world, from Japan to the US and UK. As noted in our market update on Monday, there is a chance we see higher risk premia for gilts should the Labour leadership be replaced this year – a move that could see less fiscal restraint. Nevertheless, for UK investors, the tax profile of gilts is worth a look.