Inflation and rising interest rates are subjects which are constantly in the news at the moment. The recent release of inflation numbers saw the price of UK government bonds (or gilts) drop to close to the level hit after Kwasi Kwarteng’s disastrous mini-budget. The economic drivers here are fairly simple:
1. Rising inflation usually leads to rising interest rates.
2. Rising interest rates mean that gilts with low coupon rates (set at the prevailing market rate when the gilts were issued) are unattractive and therefore their prices drop.
3. Therefore, gilts will generally trade at a discount to their face value and so that an investor can anticipate capital appreciation, as well as receiving the coupon.
Although interest received in respect of gilts is subject to income tax, any capital appreciation is exempt from capital gains tax. Such capital appreciation will often be achieved when a gilt is acquired at a discount to its face value, but is later redeemed at face value.
At 1 June, a £100 nominal UK gilt with an expiry date of 31 May 2024 had a coupon rate of 0.125% and traded at £96.14. Although any interest payments would be tiny (12.5p per £100 nominal), with the profit on redemption added in, this equates to a profit of £3.93 (after 45% income tax on the interest) and a net annual yield to redemption of 4.09%, which is equivalent to a savings account which pays annual interest of 7.44%. This figure is driven by the fact that £3.86 of the return is received on a tax-free basis.
The main point here is that in the current environment there are low interest rate gilts which give the opportunity for largely tax-free returns up to redemption. Higher rate tax payers may want to consider hunting out these opportunities in order to secure attractive post-tax returns.
Forbes Dawson view
High tax paying individuals who hold significant sums in cash should almost certainly be reviewing the advantages of gilts over existing savings arrangements. If the individual can get comfortable with the risk profile of gilts (which is traditionally seen as low) then the power of tax-free capital appreciation over a relatively short-term should trump highly taxed interest. This opportunity is particularly relevant now due to unusual market conditions which mean that gilts are trading at significant discounts to their nominal value, with only short periods of time left until redemption. Clearly, proper investment advice should always be taken.
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