A Unique Tax-Free Opportunity For British Savers

Some UK government bonds – known as gilts – currently look very attractive for savings, especially for those in the higher and additional tax brackets. See, capital gains – the profit when buying and selling an asset – on UK government bonds is tax-free.

So let’s dive into the opportunity.

How UK government bonds work

The UK government sells bonds to raise money, normally at a price of 100 pence, so each bond costs £1, its “par value”.

Bonds have a fixed interest rate (a.k.a. a “coupon”) that indicates how much interest the issuer (the government, in this case) pays to holders of the bond (i.e. investors). So if a bond has a 1% coupon and you own £100 worth of bonds, you will earn £1 of interest each year. And at maturity, when the bond expires, you’ll get the £100 you invested back too.

Interest rates in the UK, until recently, have been close to zero for about 15 years. As bond coupons are determined by the interest rates in the market at the time, they’ve been stuck at relatively low levels throughout.

Bank of England base rate from 2006 to 2023. Source Bloomberg.

What’s the opportunity here?

The Bank of England’s base rate has moved sharply higher from 0.1% in December 2021 to 5.25% in October 2023, and bonds have fallen in value alongside that rise since their prices move in the opposite direction to interest rates.

But the drop in their prices to below par (£1) provides a unique opportunity, as any profit an investor earns from buying a below-par UK government bond and selling it at a higher price doesn’t attract any capital gains tax.

The table shows a selection of UK government bonds with different expiry dates and yields.

UK government bonds expiring between 2024 and 2035, and yields-to-maturity. Source Bloomberg Oct 3rd, 2023.

A bond’s “yield-to-maturity” is the estimated total annual return from holding it until it matures (and you get your money back). It’s calculated by adding the yield from the coupon payment (called the coupon yield) to the price gain over the whole period and dividing that total by the time to the bond’s maturity or expiry.

The advantage of buying UK government bonds with both a low coupon and a price below par is that the largest part of your potential return comes from the bond’s price increase, which is tax-free. The coupon payments, which aren’t tax-free, contribute only a small part of your total yield.

To calculate exactly how much of the total yield comes from the coupon, let’s look at the UK Treasury 0.25% which matures on 31 January 2025, at a price of £0.9411. It has a yield to maturity of 4.88%, of which 0.27% comes from the coupon, so 4.61% of your yield (4.88 - 0.27) will be tax-free.

Buying 100 of these bonds will cost you £94.11. At the bond’s maturity, you’ll receive £100 as well having received interest payments along the way. If you are an additional rate taxpayer (45%), your total annual yield after tax would be 4.76%, calculated by adding the annualized price gain of 4.61% and the after-tax figure from the coupon payment of 0.15% (0.27 x 0.55).

One of the best fixed savings rates on offer currently is 6.2%, but a 45% taxpayer would only receive 3.41% after tax, so in the example, the UK government bond offers a higher after-tax return.

You can choose different bond maturities to meet your planned spending needs. But keep in mind that the prices of bonds with a longer time to expiry could fall (as they have in the last two years). So if you need to access your cash before the bonds have matured, you’re at risk of selling up at a loss.

Who can benefit from these tax-free gains?

The exact tax advantage depends on the rate of income tax you pay. The government recently reduced the “personal savings allowance” (PSA) – the tax-free amount you are allowed to earn on your savings without paying interest.

• Basic rate (20%) taxpayers have a £1,000 PSA
• Higher rate (40%) taxpayers have a £500 PSA
• Additional rate (45%) taxpayers receive a zero PSA allowance.

The personal savings allowance includes interest earned from bank or savings accounts, building societies, unit trusts, investment trusts, corporate bonds, government bonds, and life annuity payments.

With the sharp rise in interest rates over the last two years, cash savings can now offer decent returns. For example, you could get a 5.2% annual return from an easy-access account and 6.2% from a fixed account.

We saw in the example that additional rate payers will earn higher after-tax returns in owning low-coupon UK gilts than in fixed-rate saving accounts.

For higher-rate taxpayers (40%) who have a £500 personal savings allowance, these low-coupon UK government bonds can also produce a better after-tax return. For instance, with £10,000 of savings, a higher-rate taxpayer can earn £620 (£10,000 x 6.2%) in interest from a one-year fixed account, £120 more than the personal savings allowance. And sure, they’d therefore be on the hook to pay 40% tax on the £120 which would cost £48. Their after-tax return would therefore be £572 (£500 + £72), or a 5.7% return.

For higher-rate taxpayers to generate higher after-tax returns than a fixed account, consider that £8,064 will earn £499.97 in interest income, using up almost all their PSA. So savings above £8,064 would earn a higher return in low-coupon UK government bonds than in a high-interest savings account.

For basic rate (20%) taxpayers, there is no advantage in holding UK government bonds as they can earn a higher after-tax yield in a one-year fixed interest account paying 6.2%. See, a basic rate taxpayer would receive an after-tax yield of 4.96% (6.2% x 0.8) if they entered a one-year fixed-rate account, higher than the 4.88% yield offered by the UK government bond.

In this guide, you’ve learned:

• The UK government sold bonds with low coupons for many years as interest rates had been close to zero.
• Now rates are rising, there’s a unique opportunity to benefit from price gains without attracting capital gains tax.
• UK government bonds with a low coupon and that are trading below par can provide higher after-tax returns than savings accounts for higher and additional rate taxpayers.