Rising rates make government bonds attractive again

‘It’s a pretty shocking display from an asset that’s supposed to be safer than houses’

They were once used to fund wars in foreign lands and build railways across the empire, but DIY investors have been ignoring government bonds for years.

The 2008 financial crisis triggered an era of rock-bottom interest rates that pushed up their prices, resulting in lacklustre yields.

However, rising interest rates have now led to a sharp reversal, with yields hitting their highest for a decade in October. It is why experts are now once again urging investors to consider the overlooked asset class.

What’s more, a combination of tax breaks and discounts on prices to encourage savers to invest means the effective rate of return from the investment is far higher than many believe. In fact it is now possible to get returns as high as 6.6pc in under a year thanks to the tax benefit, figures suggest.

A government bond, or “gilt”, expiring at the end of January 2024 pays a coupon – interest rate – of just 0.125pc and can currently be bought for £ 97 for every £ 100 worth of debt. Investors receive the full issue price upon the bond’s redemption and pay no capital gains tax.

According to wealth advisers RBC Brewin Dolphin, for a higher-rate taxpayer, that works out at a gross yield of 6.1pc. For an additional-rate taxpayer, the yield is even higher, at 6.6pc.

Rob Burgeman of the firm said gilts now offer a high-yielding alternative to cash. “Rarely have gilts been more tax efficient,” he said.

Jason Hollands, of investment platform Bestinvest, said: “After years of being completely off the radar of most private investors, sovereign bonds are worth considering again.”

Last year, the mini-Budget triggered a sell- off in government bonds which caused prices to drop.

Laith Khalaf, of investment firm AJ Bell, said: “Since the beginning of 2022, the average gilt fund has fallen by 22pc, a pretty shocking display by an asset that’s meant to be safer than houses. But that repricing has made gilts more attractive than they were.”

Research from RBC Brewin Dolphin shows that, since last year’s bond market crisis, yields have stabilised at around 3.5pc or more. The current yield on a gilt expiring in January 2025 is 3.7pc – up by 1.3 percentage points since before the mini-Budget.

Meanwhile, the benchmark 10-year gilt yield currently sits at 3.5pc. “That compares to just 0.1pc in the depths of the pandemic,” said Mr Khalaf.

These yields are higher than the rates on most easy access savings accounts. Data from financial analyst Moneyfacts show that the best rate savers can get right now is 3.4pc. This suggests savers would be better off parking their wealth in gilts and not cash.

Investors are taking notice of these attractive yields. In the first quarter of 2023, they poured a record £2.75bn into fixed income funds – which include government and corporate bonds – according to the global funds network Calastone. The yields on government bonds are even more appealing once you factor in the added tax benefit.

Although income tax is paid on the interest you earn from gilts, any gains you make are free from capital gains levies. This means any increase between the price of the bond when you buy it and when it matures is taxfree. If the bond’s purchase price and its interest rate are low, then a chunk of the return is likely to come from the capital increase as opposed to the income.

“That can lead to more sophisticated investors trying to identify gilts with low income yields and high capital gains to manage their tax liabilities,” Mr Khalaf said. This is about as close as you can get to a guaranteed return. Gilts are seen as the ultimate safe haven investment because the risk of the Government defaulting is low. There are a number of ways to increase your exposure to gilts. “Most popular brokers offer opportunities to buy conventional gilts, and you can also purchase from the government Debt Management Office’s (DMO) gilt purchase and sale service,” said Mr Burgeman.

Alternatively, you could choose to invest in gilts through a fund. Mr Hollands suggested the iShares Core UK Gilts UCITS ETF, which has low ongoing costs of 0.07pc. Another option is the Lyxor FTSE Actuaries Gilts ETF.

It is advised that you invest in gilts in a diversified portfolio. “For longterm investment, shares are generally a better bet than gilts,” Mr Khalaf said.

According to a study from Barclays, over a 10-year period, shares have a three in four chance of outperforming gilts. Mr Khalaf said: “None the less, gilts can be a useful part of a portfolio for those who wish to reduce volatility. Gilts tend to do better in times of financial stress, often when share prices are tanking, and so by holding both in a portfolio you can achieve a smoother ride.”