UK gilts becoming a tax-efficient option for high-earning savers

Rising interest rates and falling bond prices mean high-earning savers can benefit from the tax treatment of short-dated government bonds for the first time in more than a decade, according to analysis by wealth manager Brewin Dolphin.

UK government bonds or “gilts” have been an unattractive option for savers since the financial crisis of 2008 ushered in an era of rock bottom interest rates, pushing up bond prices and leading to paltry returns.

However, bond prices have been falling since the Bank of England embarked on a series of interest rate rises from December 2021. The yield — which includes both the coupon rate paid by a bond and the difference between its price and its value at maturity — has become increasingly attractive.

“After a prolonged period of dismal yields due to a decade of very low interest rates and quantitative easing, the nominal yields on government bonds are starting to be relevant again, having risen sharply this year,” said Jason Hollands, managing director at Evelyn Partners.

The tax advantage for bondholders is that while income tax is payable on the coupon, no tax is paid on the capital increase between the purchase and sale price — or its maturity value — regardless of the bondholder’s tax band. The discounts on short-dated bonds with a low coupon value offer the most attractive tax advantages.

On August 24, for example, a UK gilt with an expiry date of January 31 2024 paid a coupon of 0.125 per cent and traded at £96.22 — providing an annual equivalent yield, with no tax paid, of 2.84 per cent.

This is lower than the best available savings rates. According to finance website Moneyfacts, savers can achieve an annual rate of 3.2 per cent for a one-year fixed rate deposit and 3.47 per cent for a two-year fixed rate.

But when tax has to be paid — after an individual savings allowance (Isa) and the £1,000 personal savings allowance have been used up — the gilt becomes more attractive, particularly for higher and additional rate taxpayers.

Brewin Dolphin calculated that the yield after tax for the bond expiring on January 31 2024 was 2.79 per cent for higher-rate taxpayers and 2.78 per cent for additional-rate taxpayers.

If the bondholder had to pay income tax on the capital uplift as well as the coupon, the yield would have to be 4.65 per cent for higher rate taxpayers and 5.06 per cent for additional rate taxpayers for the saver to achieve the same net yield — known as the “gross equivalent yield”.

Rob Burgeman, senior investment manager at Brewin Dolphin, said this was “not a bad return by any stretch of the imagination, even by current standards with inflation at 10 per cent,” adding it is a “very low risk alternative to cash on deposit”.

However, not all bonds are equal. Bonds which are inflation-linked or pay a higher coupon will trade above or closer to their issue price. You cannot use any capital loss on redemption to offset tax on gains elsewhere in your portfolio.

Rob Morgan, chief analyst at Charles Stanley, said that two-year gilt yields are “starting to stack up” as an alternative to cash. “Locking that in now may be worthwhile as, although fixed term cash rates can be found for a little more, the tax position might tilt the balance in favour of the gilts in some instances.”