Investors are snapping up gilts thanks to tax incentives – but is your money better off elsewhere?

UK government bonds, also known as gilts, are proving popular with investors so far this year, thanks to higher interest rates and the attractive tax incentives they offer. Should you invest in them?

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Investor demand for gilts has tripled compared to a year ago. That’s according to the latest data from Hargreaves Lansdown, which looked at first-quarter buying activity in 2023 versus 2024.

Gilts currently look attractive to investors thanks to the higher interest rate environment we are experiencing. The interest you earn on bonds is influenced by the prevailing interest rate environment – which means bonds in general are now offering a far more attractive level of income than at any point since the global financial crisis.

Another key reason investors are snapping up gilts, though, is that they offer strong tax incentives. You do not have to pay any capital gains tax on gilts you hold directly (this rule differs if you hold gilts in an investment fund). This is particularly attractive to investors now that the capital gains allowance has been slashed to £3,000 from 6 April this year, down from £6,000 last tax year and £12,300 the year before.

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However, a key consideration when making any investment is opportunity cost. Before stashing a large sum of money in gilts, it is important to assess whether you could earn better returns (while taking on a similar amount of risk) in a different asset class. For example, how do gilts compare to investment grade corporate bonds? We look at the pros and cons.

What are gilts?

Gilts are UK government bonds, issued by HM Treasury. When you buy a gilt, you are essentially loaning the government money for a defined period of time. In return, it pays you interest and promises to repay the loan on a set date in the future. You can buy gilts with a range of different maturities, from a matter of months up to several decades. 

Gilts are very low risk investments, because the chance of the UK government defaulting is virtually nil. This is part of the reason why they are called gilts, which means “to be thinly covered with gold leaf or gold paint”. The other reason behind their name is that, historically, the debt certificate lenders received had gilded edges. 

Is now a good time to buy bonds?

Bonds, also known as fixed income securities, look more attractive today than they have for a long time. 

In the years that followed the Global Financial Crisis, we lived through an ultra-low interest rate environment. This meant that bonds spent some time in the wilderness. Inflation was typically higher than interest rates, meaning that many bondholders were losing money in real terms. 

However, in a bid to tackle inflation in the aftermath of the pandemic, the Bank of England raised interest rates fourteen times between December 2021 and August 2023. Ever since, it has been holding them at their current level of 5.25%

When interest rates were rising in 2022 and 2023, it created a challenging environment for bondholders. However, now that interest rates have peaked, it looks like smooth sailing ahead. The reason for this is that bond prices on the secondary market fall when interest rates rise. This makes sense when you think about it – why would you buy a second-hand bond offering 2% interest when you can buy a brand new bond offering 3% interest?

While the second-hand value of bonds fell in 2022 and 2023 when interest rates went up, the silver lining is that the “income” in “fixed income” is now back. If you buy a new bond issued today, the level of income on offer will be considerably higher than you could have earned on a bond you bought a few years ago. 

What’s next for the bond market?

Interest rates now appear to have peaked, which is good news for the bond market. It means you can earn a decent level of income, and the risk of bond prices falling on the secondary market is considerably lower than it was a couple of years ago. In fact, when the Bank of England starts cutting interest rates, second-hand bond prices should actually go up.

“Current market pricing is suggesting that interest rates in the UK will be around 3.25-3.5% in five years’ time”, says Hal Cook, senior investment analyst at Hargreaves Lansdown. “When inflation falls and the central banks cut rates, bonds appeal more to investors. This increases demand, and pushes the price up – so investors who are holding bonds will see the value of their holding increase.”

Should you buy gilts, or focus on other areas of the bond market?

The bond market in general is offering good income opportunities at the moment – but why are investors snapping up gilts in particular? There are a couple of key factors at play. 

Safe-haven buying

Firstly, the world is a volatile place right now. We are witnessing ongoing geopolitical volatility with the war in Ukraine and heightened tensions between Israel and Iran in the Middle East. What’s more, almost half the world is going to the ballot box this year. 

On top of this, there are fears that higher interest rates could start to take their toll. The UK economy dipped into recession in the final three months of 2023 and, while economic growth has looked stronger so far this year, it is still modest. 

Gilts are often considered “safe-haven” investments because the risk of the UK government defaulting is very low. This means investors often flock to them during periods of turmoil, because they feel it is safer than having their money in riskier investments like equities. 

Against this backdrop, the increased demand for gilts is unsurprising. Other safe-haven assets like gold have seen big inflows so far this year too, with the gold price soaring to record highs in recent months. 

Tax incentives 

On top of this, gilts offer some compelling tax incentives. While any income earned from the investment is taxed in the usual way, investors are not required to pay capital gains tax on any gilts they hold directly. 

“For some investors, particularly those who pay higher rate tax, this has made bonds that have small coupons (interest payments) very appealing”, explains Cook. “They’re appealing because the coupons are taxed as income, but the rest of the return counts as a capital gain. As capital gains from gilts aren’t taxed, you get a better overall return after tax if the coupons are small.”

This might sound counterintuitive, particularly when you consider the arguments we have just laid out about investors rushing into bonds to take advantage of the higher coupons now available. However, it all comes down to how bond prices fluctuate on the second hand market. 

When interest rates go up, bonds with lower coupons fall below their face value on the second hand market. This allows investors to snap them up at a discount, knowing that the loan will be repaid in full when the bond matures. The lower the coupon rate on the bond, the bigger the discount on the second hand market. You can make a decent return by doing this – and it is entirely tax-free.

Gilts versus other areas of the bond market

When weighing up the pros and cons of investing in gilts, it is important to look at your own individual circumstances. What income tax band are you in, and have you already maximised your annual ISA allowance?

If you are opting for a gilt with a low coupon in an attempt to be tax efficient, you need to make sure that your overall return is definitely higher than you could secure from a higher yielding gilt held in an ISA or SIPP. 

You should also consider the opportunity cost of tying your money up in gilts compared to other asset classes. For example, investors can earn a higher level of income by investing in investment grade corporate bonds, without having to take on too much additional risk. It is important to size any tax efficiencies from gilts against the potential for higher returns in other asset classes. 

We asked Hargreaves Lansdown for their thoughts on how the two different parts of the bond market compare. Cook said: “It’s difficult to fully allow for the impact of the tax differences between gilts and corporate bonds because this will depend on which gilt(s) are purchased and the tax situation of the individual.” 

“However, broadly speaking, corporate bonds are expected to provide a higher return than gilts where markets are relatively calm, and investors are rewarded with higher yields as they lack government backing.”

If there is a market shock, however, the dynamics can shift slightly again. “[I]nvestment grade corporate bonds do not benefit as much from a flight to safety compared to gilts, as investors tend to look for safety in government bonds”, Cook explains. “Corporate bonds could potentially lose value in this situation, or if they do gain in value, the gain will be lower than that of gilts”, he added.

Katie Williams
Staff Writer

Katie has a background in investment writing and is interested in everything to do with personal finance and financial news. 

Before joining MoneyWeek, she worked as a content writer at Invesco, a global asset management firm, which she joined as a graduate in 2019. While there, she enjoyed translating complex topics into “easy to understand” stories. 

She studied English at the University of Cambridge and loves reading, writing and going to the theatre.