Sam Benstead breaks down the latest news affecting bond investors.
Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.
Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.
Here’s what you need to know this week.
Capital gains tax break makes gilts even more appealing
Two-year gilt yields are now at their highest level since 2008, returning more than 5% for investors who hold them to maturity.
Expectations that interest rates will have to reach 6% in the UK to finally break the inflationary cycle are pushing yields higher, as investors sell bonds.
Interactive Investor customers are spying opportunity. Since the start of 2023, trades in direct fixed income by value have increased 879% year-on-year. Most of the purchases, 95%, have been gilts.
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They currently pay low coupons and trade below par, meaning that most of the 5% return will come when the bonds pay back their £100 principle on maturity.
Capital gains on gilts, either by selling a gilt on the secondary market or waiting for them to redeem, are free from capital gains tax. Higher rate and additional rate payers are taxed at 20%, while basic-rate payers are taxed at 10%.
The shrinking CGT-free allowance makes banking a return on gilts even more attractive. This year the allowance has dropped from £12,300 to £6,000, and it will fall to just £3,000 in the 2024-25 tax year.
Where’s the income from my inflation-linked bonds?
To the surprise of many investors, index-linked gilt funds are not paying out any income, even as inflation has soared, which should in theory boost the coupons paid out to investors.
Two of the leading index-linked gilt tracker funds, iShares £ Index-Lnkd Gilts ETF GBP Dist (LSE:INXG) and Vanguard UK Inflation-Linked Gilt Index , have not made any distributions since November 2020 and February 2013.
For investors who owned the income share classes in the hope that they would see a rising coupon with inflation in the UK at 8.7%, this is very puzzling.
I spoke to BlackRock and Vanguard about why this was. The answer is a tricky accounting practice called amortisation that means that the income is being added to the capital value of these funds and not paid out, even in the income share classes.
Vanguard explains: “Revenue (income) from debt securities is accounted for on a basis which takes account of the amortisation of any discount or premium between the purchase price and the expected final maturity price over the remaining life of the security. The effect of this has been to require reclassification from income to capital of the fund, which has resulted in negative net income available for distribution in recent years.”
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BlackRock adds: “The lack of distributions in the last cycles is a result of premium amortisation exceeding accrued interest earned. This is largely due to the historic low rate environment and older bonds in the fund trading at a premium, which requires the average cost of bonds (above par value) to be amortised over the remaining life to maturity.
“Amortisation decreases distributable income but is offset equally by an increase to capital, so the overall economic impact to investors is neutral. The opposite occurs when bonds are trading at a discount to par as accretion is applied to bonds, which increases income.”
In summary, investors are benefiting from higher coupons, but the gain is being added to the capital value of the fund and not being paid out as income.
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