A strange time to talk about capital gains tax on gilts. In the midst of a year in which they’ve delivered historic losses!

I imagine you’ve seen the headlines. How gilt1 prices cratered in the wake of the Mini Budget. How the Bank of England tried to smooth things over.

Gilts have now fallen so sharply that their expected return profile has changed dramatically.

Going into 2022, gilts were trading well over par.2 Investors hungry for yield had bid up gilt prices for a decade.

A capital loss was guaranteed, sooner or later. That was because the money you’d get back when the gilt was redeemed would be less than you’d paid when you bought the gilt above par value.

Now though, the vast majority of gilts are priced below par.

So as well as the regular coupons you receive as a holder of a gilt – interest, essentially – you’ll also make a profitable capital gain if you own the gilt when it matures.

Gilts: a turnaround story

This all matters a lot for investment – not least because I’m seeing lots of readers talking about dumping their UK government bonds.

Even passive investors!

Caught between a rock and a hard place in trying to prudently diversify their portfolios, they’ve held gilts for years even as the outlook for returns dwindled.

But now, after a truly dire year for government bonds, some seem ready to throw in the towel.

However before you do anything it’s important to understand the reversal in gilts’ prospects.

As I write, even index-linked gilts are sporting a small but positive yield-to-maturity (YTM).

Yes, you can now guarantee a return over inflation by buying and holding these government bonds until they mature.

In contrast, as recently as the end of 2021 you had to pay the government for the privilege of inflation-proofing your capital. Very long duration index-linked gilts were on a YTM of negative 2%!

The picture is more opaque when it comes to government bond funds, which is how most people hold their gilts, because the funds hold a rolling stock of gilts.

But they own the same underlying securities – gilts – and the overall message is the same.

Gilt prices – and hence yields – will probably continue to be choppy, not least given the political turbulence in the UK.

But the important thing is not to judge UK government bonds by what they’ve done recently. But rather by what they’re priced to potentially do now.

Nice curves

Here’s what at M&G Investments’ pros – the self-styled Bond Vigilantes – have to say about it today:

Inflation protection is looking attractive (or sensible) again. The last month has pretty much seen the whole UK linker curve move from negative yields into positive territory.

This means that for practically any period of your choosing, you can now receive a guaranteed return above inflation, instead of paying for the benefit of owning that protection.

Again, given the current economic climate, this feels like an interesting trade for the long term investor.

You can see this in the following graph:

Don’t worry if talk about ‘curves’ and whatnot is a bit over your head.

The important point is that the green line – the YTM available now – is above zero for all but the very shortest duration index-linked gilts.

In contrast the yellow line shows that just one month ago index-linked gilts were priced to deliver a negative return.

This shift is why your existing UK government bonds are in the red. But it’s also why returns should be much better from here.

Capital gains and coupons

What’s more, if you’re an active investor and you’re thinking about buying gilts for tactical reasons to take advantage of these shifts, then you need to think a bit more about their return profile.

The way that capital gains tax on individual gilts works – there’s none, in short – means you might want to hold them outside of tax shelters. That way you leave more room in there for your tax-liable stuff.

If however you struggle to fill your ISAs and SIPPS, then you can skip the rest of this article. (Just buy your gilts inside tax shelters, where they are safe from income tax too.)

Gilts versus gilt funds: Note that when I say gilts are capital gains tax-free, I’m referring to individual gilts. Gilt funds are a different matter – they are liable for capital gains tax – and index-linked gilt funds differ slightly again. See our article on how bonds and bond funds are taxed.

Remember there are two components to the return from gilts.

The coupon

This is the fixed interest coupon the gilt pays every year. It varies by individual gilt issued.

For example ‘Treasury 0.125% 2039’ gilt will pay you 0.125% of its face value a year until 2039.

The redemption value

This is the amount you get back when a gilt is redeemed.

For example Treasury 0.125% 2039 has a par value of £100. As I write it only costs £80 to buy.

Therefore if you bought this gilt and held it until 2039, you would make a £20 (25%) capital gain when it matured and was redeemed.

Note that prices are moving around a lot for gilts at present, so these prices may be long gone by the time you read this. Also spreads are wider than usual.

Combining the two: redemption yield, or yield-to-maturity

By far the most important yield we need to worry about is the yield-to-maturity (or YTM).

This is tricky to calculate because it seeks to estimate your annualised return, taking into account both the coupon payments from the gilt and any capital return (or loss) on maturity.

Why is that difficult?

Well, think about it. I just told you that Treasury ‘0.125% 2039’ is going to be worth 25% more when it matures in 2039.

If you can wait for 17 years then you’re guaranteed to bank a profit.

However everyone in the gilt market knows this. (My phone is not ringing off the hook as hedge funds ply me for more secrets.)

We can therefore assume that the price will – more ‘shock and poor’ volatility aside – tend to move towards par value between now and 2039.

We’ve seen this year that the path towards par value won’t be smooth.

Sometimes the gilt’s price will be up, other times down. We can’t know how exactly in advance.

But to do a YTM calculation, we – or in practice a calculator – have to make assumptions about reinvesting the coupon into this series of unknowable prices.

Which is tricky.

All 99% of investors need to know though is that the YTM provides the best guesstimate to the return you’ll get from a bond if you buy it today.

Moreover it’s not in the same category of finger-in-the-air guesswork we’re forced to do when we estimate future returns from equities, say. There’s solid maths behind the YTM calculation. Solid, but not 100% accurate, if that makes any sense.

The other snag is it’s hard to find yield-to-maturity quotes for free on the Web.

City pros use a Bloomberg. Retail sites quote coupons or running yields, which aren’t so helpful.

However you can sign-up to download YTMs based on yesterday’s closing prices at TradeWeb. You need to register, but it’s free.

There’s no capital gains tax on individual gilts

At last we get to the much-trailed important bit about capital gains tax on gilts!

Remember, the yield-to-maturity is made of two components – the capital gain and income.

For all investors, the capital gain portion is tax-free with gilts.

Most investors will be liable to pay income tax on the coupon (outsider of tax shelters).

Now something that’s pretty clear in the name ‘Treasury 0.125% 2039’ is that the coupon is very small. It’s just 0.125%.

Moreover the interest you get from your coupon counts as savings income. Which means savings income tax rates apply – including the starting rate for savings and the savings nil rate band.

Perhaps you won’t even be liable for income tax on the coupon, in some circumstances.

More usually though, the sort of person who buys individual gilts with their tax situation in mind will pay income tax on savings.

So they will be interested in minimizing the income coupon and maximizing the tax-free capital gain.

How to pick gilts for fun and profit

In a sentence: if you’re looking to buy and hold individual gilts to maturity, you want to pay attention to your tax situation – both now and in the future – before you decide which issues to buy.

We can assume all gilts have the same (extremely low) chance of default. They’re all backed by the UK government, which can print its own money. It’s not like with other types of bonds or shares where you need to diversify.

So choosing a gilt based on the tax profile makes sense.

Everyone’s tax situation is different. But in general, higher and additional-rate taxpayers might want to look at short-dated gilts trading below par with a low coupon but an attractive YTM.

This maximizes the tax-free gains. The coupon is low, so not much return is lost to income tax.

You’ll also want to compare your after-tax YTM from gilts with that from cash savings, taking into account your particular circumstances.

Incidentally years ago you’d see suggestions as to which gilt would suit which bracket of taxpayers in print magazines. Possibly even the weekend newspapers, unless my memory is playing tricks.

Unfortunately though, I can’t point you to such a source today. (If anyone has a lead, let us know in the comments below.)

Note that if you sell your gilt before it matures for less than you paid for it – that is, at a loss – you can’t set that loss against capital gains you make elsewhere.

Individual gilts are outside the whole gains/losses merry-go-round from a capital gains tax perspective.

Gilts: down but not out

To recap, it has been a very ugly year for bonds of all types.

Inflation has persisted, causing central banks to raise interest rates. That’s hammered bonds that were seemingly priced for low rates forever. The situation was made worse in the UK by the tumult around the Mini Budget and fears for the UK’s long-term finances.

We wrote on Monevator many times about the risks from government bonds trading at elevated levels, especially those of long duration.

For example:

Why inflation-linked funds may not protect you from inflation (2016)How much will you lose if bond prices fall? (2020)Are bonds a good investment? (2021)

But that was mostly then, and this is definitely now.

For sure bonds could continue to chalk up dismal returns, in the short-term especially.

And while you can now get around 4% from a ten-year gilt – compared to 1% just one year ago – if high inflation lingers for years then the real return3 could still be disappointing.

Index-linked gilts do seem to me an opportunity worth grasping, given they are now offering a positive yield and inflation protection again.

But of course a 1% annual return only looks especially attractive because in 2022 everything has turned south.

Maybe shares will deliver 20% next year and you’ll regret piling into gilts for a 1% real return?

But such speculation is for another day, and mostly for another website.

The point is the return outlook for UK government bonds looks much brighter. Even as investors in the asset class peel themselves off the floor from the pasting they’ve had in 2022!

Never dismiss an asset class simply based on what it’s done for you lately.

And if you want to mess about with individual gilts, consider capital gains tax.

UK government bondsPar is the face value of a bond. That is, the price the bond was issued at, which you get back when it matures and is redeemed.That is, after inflation.

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UK government bonds are down, which is terrible news. Except that it means future returns are up!
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