Astute investors have discovered an ingenious strategy to ensure a consistent, tax-free income stream.
This method involves purchasing UK Government bonds, known for offering some of the most competitive rates, even when interest rates decline significantly.
These bonds, referred to as gilts, provide a regular payout known as a coupon. Upon maturity, investors receive their original investment back, barring the highly improbable scenario of the UK Government defaulting on its obligations.
Gilts are accessible through various investment platforms, which conveniently allow them to be held within an Isa. Financial advisers are increasingly suggesting these bonds to high-income individuals who have already maximized their Isa contributions, leveraging the tax advantages they provide (we’ll delve into this further).
Like most investment vehicles, gilts come with transaction fees and annual charges. However, more investors are employing a strategy known as a ‘gilt ladder’ in the financial world.
This approach involves assembling a portfolio of gilts with staggered maturity dates. As they mature sequentially, it minimizes interest rate risk and ensures steady income. This strategy is especially beneficial for retirees seeking to secure predictable and structured returns.
‘Gilt ladder’: Involves buying a whole basket of gilts with different end dates
The strategy is of particular interest right now because in recent months gilt yields have soared to highs not seen since the late 1990s.
The yield on ten-year UK gilts – a key measure of Government borrowing costs – was off recent highs but remained at 4.9 per cent on Friday on the back of ongoing turmoil in the Labour Party, above-target inflation and a raft of global uncertainties. Here’s everything you need to know about investing in gilts – and how to build your very own tax-free gilt ladder.
How gilts work
Governments issue bonds to borrow money, offering them with a range of different maturities, such as three months, a year, ten years, 30 years and so on. This is the length of time governments are giving themselves to pay investors back.
Short-dated bonds mature quickly and tend to be deemed less risky than long-dated bonds. This means the safer, short-dated bonds tend to pay investors less than longer-dated ones, but they can still beat savings rates from high street banks.
Build an income stream
A gilt ladder can be used to spread investments across many years, says Alan Barral, financial planner at wealth manager Quilter Cheviot.
He explains: ‘This means capital is returned in stages, providing predictable cashflows over time.
‘We have seen a significant number of clients take advantage of this opportunity, using gilts as a highly tax-efficient way of holding large cash balances outside a cash Isa.’
Investment platform AJ Bell has compiled this gilt ladder, made up of gilts that are currently trading below par – meaning you can buy them for less than they are worth at maturity, which is typically £100.
The ladder is made up of three bonds, all of which pay coupons twice a year. The shortest dated bond matures in October this year and pays a coupon of 0.375 per cent. This means you would get paid 18.75p as income if you bought now and held to maturity. The bond costs £98.50 but at maturity in October, you would get £100 back (the price it was originally issued at). That is a £1.6875 gain overall, equating to a 1.71 per cent return on investment.
The second bond matures at the end of October 2028 and pays a coupon of 1.625 per cent. This means you would get paid an income of £4.06 (five instalments of 81.25p). It is priced at £93.71 today and would pay out £100 upon maturity. The £6.29 capital gain and £4.06 income equal a total gain of £10.35, which is an 11.04 per cent return.
The third bond matures in January 2029 and pays a coupon of 0.5 per cent. This means you would receive £1.50 as interest. It is priced at £90.10 and would pay out £100 at maturity. Add the £1.50 income with £9.90 capital gain (£11.40) and you’ve made 12.65 per cent return.
To keep things simple, the yield formulas in these examples use the ‘clean price’ that does not include accrued interest between coupon payments. By buying these together, you guarantee that your income will be spread over the next three years.
The tax perks
The coupon is subject to tax, in the same way that interest is paid on cash savings. But for anyone looking to invest outside Isas (which have an annual £20,000 limit) and pensions – especially those paying higher or additional tax rates – gilts can be very tax efficient, as the price gains on them at maturity are exempt from capital gains tax.
This means you can make impressive gains on gilts with low coupons that you bought for a discount.
Dan Coatsworth, head of markets at AJ Bell, says: ‘For a lot of people, the big appeal is the gain on a gilt at maturity is tax-free. The income from the coupon is taxable but you can buy gilts maturing over the next few years paying only a small coupon, meaning the majority of the gain comes tax-free at redemption.
‘This is a huge draw when you compare gilts to a cash savings account, where the returns are taxable if you’re holding the money outside a pension or Isa.’
Coatsworth says for higher and additional rate taxpayers, the money you get back from buying short-dated gilts can far exceed what you might get from a cash account.
If doing these sums yourself sounds overwhelming, it might be worth paying a financial adviser to build a gilt ladder for you.
DIY INVESTING PLATFORMS
AJ Bell
AJ Bell
Easy investing and ready-made portfolios
Hargreaves Lansdown
Hargreaves Lansdown
Free fund dealing and investment ideas
interactive investor
interactive investor
Flat-fee investing from £4.99 per month
Freetrade
Freetrade
Investing Isa now free on basic plan
Trading 212
Trading 212
Free share dealing and no account fee
Affiliate links: If you take out a product This is Money may earn a commission. These deals are chosen by our editorial team, as we think they are worth highlighting. This does not affect our editorial independence.
Compare the best investing account for you
