Rising interest rates and falling bond prices mean high-income savers can benefit from the tax treatment of short-term government bonds for the first time in more than a decade, according to analysis from the Wealth manager Brewin Dolphin.
UK government bonds or ‘gilts’ have been an unattractive option for savers since the 2008 financial crisis ushered in an era of rock bottom interest rates, driving up bond prices and leading to paltry returns.
However, bond prices have been falling since the Bank of England launched a series of interest rate hikes 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 returns due to a decade of very low interest rates and quantitative easing, nominal government bond yields are once again becoming relevant, having risen sharply this year,” said Jason Hollands. , CEO of Evelyn Partners. .
The tax advantage for bondholders is that while income tax is due on the coupon, no tax is paid on the capital increase between the purchase and sale price – or its value at maturity – regardless of the bondholder’s tax bracket. Discounts on short-term bonds with a low coupon value offer the most attractive tax benefits.
On August 24, for example, a UK gilt with an expiry date of January 31, 2024 paid a coupon of 0.125% and traded at £96.22, offering an equivalent annual return, tax-free, of 2.84%.
This rate is lower than the best savings rates available. According to the financial website Moneyfacts, savers can get an annual rate of 3.2% for a one-year fixed rate deposit and 3.47% 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 exhausted – gilding becomes more attractive, particularly for taxpayers at higher and additional rate.
Brewin Dolphin calculated that the after-tax yield on the bond expiring on January 31, 2024 was 2.79% for higher rate taxpayers and 2.78% for additional rate taxpayers.
If the bondholder were to pay income tax on the capital increase as well as the coupon, the yield should be 4.65% for higher rate taxpayers and 5.06% for additional rate taxpayers so that the saver gets the same net return – known as the “gross equivalent return”.
Rob Burgeman, senior investment manager at Brewin Dolphin, said it was “not a bad return by any stretch of the imagination, even by today’s standards with 10% inflation”, adding that it was a “very low risk alternative to cash on deposit”.
However, not all obligations are equal. Bonds indexed to inflation or paying a higher coupon will trade above or near their issue price. You cannot use a capital loss on redemption to offset tax on gains elsewhere in your portfolio.
Rob Morgan, chief analyst at Charles Stanley, said yields on two-year gilts are “starting to accumulate” as an alternative to cash. “Locking this in now may be worth it because, although fixed term cash rates can be found for a little more, the tax situation could tip the scales in favor of gilts in some cases.”