Benstead on Bonds: are long gilts at 5.5% a no-brainer?

If someone offered you a guaranteed annual return of 5.5%, locked in for the next 20 to 30 years, would you take it?

Well, that’s what investors can get today if they put money into long-maturity gilts. The latest data puts gilts maturing in 20 years’ time at a yield-to-maturity (YTM) of 5.5%, 25 years at 5.6% and 30 years at 5.6%.

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The YTM figure assumes that coupons are reinvested and accounts for both capital and income, giving a pretty accurate estimation of annualised returns over the life of a bond.

And this yield figure is high! For comparison, 20-year government bonds in France are at 4%, Germany at 3.2% and Japan at 2.6%. It’s generally only emerging markets that yield more, and long gilt yields have not been this high since the late 1990s.

Moreover, a way of looking at the value of government bond yields is to assess the “spread”, or excess yield, that you get from owning corporate bonds. For sterling bonds, this is a little under 1%, which is historically low. This means corporate bonds are poor value compared to government bonds, because why would you take on the extra risk for just 1 percentage point of extra yield?

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When I say “guaranteed” return from gilts, I am assuming that the British government does not default given that it never has before. While this admittedly does feel increasingly possible, gilts are still as close to being risk-free as investment markets can offer, at least in terms of getting your money back and collecting the two coupons per year.

But there are some other risks with a buy-and-hold gilts strategy. The biggest in my view is inflation – if prices rise at 4% a year for 20 years and your gilt pays you 5.5%, then you are only really increasing your wealth by 1.5% a year, which isn’t much. For comparison, UBS calculates that since 1900, US shares have made on average 8.4% “real”, meaning that they have made 8.4% ahead of the inflation rate over that period. The figure for UK equities is 7.1%.

Inflation in the UK is currently 3.8% and expected to hit 4% in September, before falling back to the Bank of England’s 2% target at the end next year or in early 2027. While it may return to 2% and stay there, there are no guarantees. One useful indicator of where investors think inflation will be is to look at the yield offered on index-linked gilts, which pay a return ahead of the RPI inflation rate.

A 20-year index-linked gilt currently has a yield of 2.4%, according to Tradeweb, which suggests that RPI will be about 3% a year over the next 20 years, based on the difference in yield between a 20-year inflation-linked gilt and a 20-year regular gilt. For investors worried about inflation, and who think it will be above this figure and are eventually proved right, the index-linked option could make a better investment.

While gilt returns are (nearly) guaranteed, investors must be aware that gilt prices will fluctuate a lot, particularly those that mature in 20 to 30 years. On their way to return £100 per gilt owed to the holder on maturity, prices will move due to changes in market conditions.

Say you own the TG50 (UNITED KINGDOM 0.625 22/10/2050) gilt, maturing in 25 years’ time. The price today is £35 and on 22 October 2050 it will mature and pay the owner £100. Along the way, 62.5p in coupons are paid each year. Taken together, the YTM is 5.4% annualised.

However, that 5.4% yield may become too generous or too dear depending on what happens in markets.

For example, if interest rates shoot up, then bond prices will have to fall so that yields will come into line with market prices. This would mean a big paper loss for gilts.

And a big jump in yields is definitely possible. Peter Spiller, manager of Capital Gearing Ord (LSE:CGT) investment trust for more than 40 years, sees lots of risks ahead for gilts, especially longer maturity ones, where prices are sensitive to the creditworthiness of the UK government.

He says: “One of the most significant issues facing this government is rising interest costs against a backdrop of spiralling debt.

“The behaviour of yields on long-term gilts – the government’s cost of finance, a proxy for market confidence in public finances – suggests a fear that fiscal dominance, where interest rates are dictated by the budgetary needs of government, is a real threat.”

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Jason Borbora-Sheen, a fixed-income portfolio manager at Ninety One, says that very few investors really have a time horizon long enough to hold 30-year gilts until maturity, and that the sweet spot for investors looking at gilts is normally below 10 years. His view is that there is a lot of risk in longer-term gilts and investors are better served at the shorter end of the yield curve.

He said: “The UK has a reliance on external funding and is in a poor financial position, which makes long gilts a risk proposition. Any duress in fixed-income markets will be felt hardest in these long gilts.”

So, while investors know that they will get £100 back per gilt owed, they could see their gilts drop in value over their life, which although not a financial problem if there is no need to sell, will definitely not feel great, especially if it’s a large position. On the other hand, long-term gilts could rise in value, giving holders a big paper gain. 

High or low coupon gilts?

It is important to look at the size of the coupon as well if considering a long-maturity gilt. If the coupon is in line with today’s yield of around 5.5%, then the gilt will trade at around its £100 redemption value. This means that the return will come from coupons and not capital gains, which may suit investors better if they want to generate a reliable annual income from their investment.

On the other hand, if the return predominantly comes from capital gains (which are tax free outside an ISA and SIPP), then the pull to par (the £100 redemption value) is what can make up the bulk of returns. Gilts that have coupons below the market yield today will trade at a discount to the redemption value, which means that capital gains will form part of the return. The lower the coupon, the lower more impact capital growth will have.

Because this tax break is well known, it has pulled lots of capital into low-coupon gilts compared with higher coupon gilts maturing at a similar time, which has had the effect of lowering yields.

If you’re looking at long gilts, then here are some popular ones that could be researched further. I’ve included a selection of high and low coupon gilts.