Everything you need to know about investing in gilts

From understanding yields and tax breaks, to picking the right bond, Sam Benstead has the answers. 

Bonds issued by the UK government, known as gilts, are back on the radar of investors due to their higher yields, which offer investors a greater level of income.

But to start with, let’s take a step back and explain what a gilt is, and how bond prices and bond yields work in practice.

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What is a gilt?

Investors buying gilts are lending money to the government, known as the principal, which operates like an IOU. While waiting for the money to be repaid at a specified date in the future when the gilt matures, investors are paid interest at a fixed rate known as the coupon. This payment typically happens twice a year.

Gilts are lower-risk compared to other bond types – such as corporate bonds – due to the security of the issuer, which is the UK government.

Over the past decade, the income offered by gilts – the yield – has been very low. However, this has dramatically changed over the past 18 months on the back of interest rates rising from just 0.1% to 5%. Interest rate rises have caused the prices of gilts to crash, sending yields higher. Investors sell bonds when interest rates rise, as they know they can get a better deal on newly issued debt.

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The yield is the annual return that an investor who’s bought the gilt after the issue expects to receive as income over the next 12 months.

Bond prices and bond yields have an inverse relationship, so falling gilt prices mean higher gilt yields. When gilt prices rise, yields fall. 

Usually, bonds with longer lifespans such as 30 years have higher yields than shorter-duration bonds to compensate investors for lending their money for longer. 

However, at the moment, the so-called gilt yield curve is inverted, meaning that shorter maturity bonds yield more than longer maturity bonds. This is because investors expected interest rates to rise in the short term to fight inflation, but then fall in the medium to long term to stimulate the economy.

The table below shows the yields on offer from key UK gilt maturities.

Source: MarketWatch, 30 June 2023

Investors can buy gilts directly or invest in actively or passively managed funds that hold them. But understanding how to buy them, and how they are affected by markets, is not always straightforward.

Gilt yields explained

The yield on a bond is the relationship between the price of the bond and the coupon it pays. As explained above bond yields move inversely to bond prices. When bond prices rise, yields fall, and vice versa.

The running yield, which shows how much will be distributed annually as income, is calculated by dividing the coupon by the price, and multiplying by 100.

For example, a bond issued at £100 with a 5p coupon, has a yield of 5%. However, if the price rises to £200, the coupon is still 5p, but the yield falls to 2.5%. In this scenario, those who bought when the bond was issued, can now sell at double the price they paid.

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If the price falls to £50, the coupon remains at 5p, but the yield is now 10%. While the amount expected to be paid in income is now relatively higher, those who bought at issue and decide to sell will be doing so at a loss of 50% on the price paid. For new investors, the higher yield and cheaper price on offer are more attractive.

The yield to maturity, which incorporates the gain or loss when the £100 principal of a gilt is returned, is another yield to be aware of, as it can vary greatly from the running yield.

For example, TN25, a gilt maturing in January 2025, has a coupon of 0.25% and price of £92.50. This means the running yield is 0.27% (0.25 divided by 92.5, multiplied by 100). However, including the £100 returned to investors when the bond matures, the total gain of holding this bond to maturity is currently 5.4%, according to data provider Refinitiv. Yield to maturity is most useful for investors looking to hold bonds to maturity.

Why gilts are falling in price

The main driver of gilt prices rising or falling is interest rates. When interest rates rise, any new gilts issued come with higher coupons. This makes existing gilts less attractive, causing their price to fall.

Interest rates are rising to cool the economy and bring down inflation. Higher borrowing costs are set to have an enormous impact on mortgage costs for millions of households, with the Institute of Fiscal Studies calculating that on average disposable incomes will fall by 8.3%, with those aged 30 to 39 experiencing the biggest hit (declining by almost 11%).

The reverse scenario plays out when interest rates are cut. Newer gilt issues pay less in interest, which in turn makes existing gilts look more attractive

Understanding direct gilts

Finding the right gilt to invest in and understanding what you are buying is not always straightforward.

Gilts follow the same naming pattern, and all look something like this: Treasury Gilt 0.25% 31/01/2025 (TN25)

Treasury gilt, sometimes shown as just Treasury or United Kingdom, shows that it is a bond issued by the UK government.

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The next number will be the initial coupon paid, expressed as a percentage. This shows the yield that the investors who participated in the bond issue were able to obtain. The bond may have issued slightly above or below the par value of £100, depending on investor demand, which therefore might change the initial yield that investors got.

The date is the maturity date of the bond. This is when the final coupon payment is made and the £100 par value of the bond returned to those who own the bond. Coupons are paid twice a year.

TN25 is the stock market ticker for the bond. You may also see T, TR or TG. The number refers to the year the gilt will mature.

How to invest

Interactive investor offers around 100 gilts on the platform. The most popular ones can be traded online, while some may have to be traded over the phone. Online dealing costs are charged, rather than the higher phone dealing charge.

Tax breaks explained

Income from gilts, coming from the coupon paid twice a year, is subject to income tax if not held inside an ISA or a SIPP.

However, capital gains from selling a gilt or when it redeems are not subject to capital gains tax. This makes them a useful tax-planning tool for investors who have used up their ISA and SIPP allowances.

For some gilts, most of the total return is when the gilt redeems at £100, meaning that the capital gains tax savings are significant.

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What about index-linked gilts?

The UK government also issues index-linked bonds, where returns are linked to the RPI inflation rate. Aimed at large investors who need to secure an income above inflation, they are generally very long duration bonds, meaning that they take a long time to mature and pay back the bond owner in full.

For example, 30% inflation over a five-year maturity period will lead to a bond issued at £100 paying back £130 on maturity, with coupons also adjusted for inflation as well.

Inflation-linked bonds will generally rise in price when interest rates fall, just as normal bonds do, but will also perform well when inflation rises, which is a scenario that may hurt normal bonds as the real value of their coupon will be eroded.

Rising interest rates will hurt inflation-linked bonds as they do normal bonds, so a scenario of high and rising inflation without higher interest rates is ideal for this type of bond. Inflation-linked bonds, due to their longer maturity lengths, tend to be more sensitive to interest rate changes than regular bonds.

Investors can buy inflation-linked bonds directly, or they can buy a fund of them, such as the iShares £ Index-Linked Gilts UCITS ETF. Index-linked gilts are more complicated than regular gilts due to how they calculate coupon payments and the final principal amount, so require more research.

For example, the iShares ETF has not made an income distribution since 2020. This is because of an accounting practice called amortisation that means income is being added to the capital value of these funds and not paid out, even in the income share classes. 

Index-linked gilts follow the same naming pattern as regular gilts, but normally include “IL” in the name. For example, TR24 is an index-linked bond maturing in 2024. Its full name is 0 1/8% IL TR GILT 2024, according to the London Stock Exchange.

Which gilts are ii customers buying?

As at the time of writing at the end of June 2023, interactive investor customers are buying up gilts set to mature in the next couple of years, with bonds maturing in 2024, 2025, and 2023 as the three most-popular choices. This suggests investors are holding the gilts to maturity, locking in yields of more than 5%.

Given that TN24, and TG23 are low coupon bonds trading below par, most of the returns will come when the gilt pays back its £100 principal on maturity. This capital gain is tax free, making these gilts especially attractive for investors who have used up their ISA allowance. In addition, cuts to the tax-free capital gains allowance are making gilts an even more effective way of reducing tax bills.

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One gilt that stands out is TG61, a bond with just under 40 years until it matures. Long-dated bonds are most sensitive to changes in interest rates, and so will generally fall in value the most when rates rise, but rise the most when they fall.

The popularity of this bond suggests that some investors could be betting that interest rates will fall faster than the markets expect, and they hope to sell the gilt for a capital gain before it matures. This is also tax free.

These are the most popular gilts on the interactive investor platform over the year-to-date 2023:

• TN24
• TN25
• TG23
• TG61
• TR25
• T23
• TR28
• TG24
• TR27
• T42
• TR38
• TR32