UK Bonds: Shield Your Portfolio From Inflation and Volatility

Bring up gilts in conversation and you are likely to be met with a glazed expression — or a flicker of anxiety.

For plenty of private investors, UK government bonds have long seemed too dull to deserve much attention.

Others worry that gilt prices could come under pressure if public spending rises further, with Britain’s national debt already close to £3 trillion — roughly 95 per cent of the country’s annual economic output.

Yet a number of hedge fund managers are now looking at the UK gilt market with far more optimism — and their view may be worth considering.

Their argument is that much of the gloom surrounding gilts is already reflected in prices. At the same time, these government bonds may offer a useful refuge as investors grow increasingly uneasy about the vast sums being poured by US technology giants into artificial intelligence.

Hedge funds, whose job is to seek returns in both rising and falling markets, are being drawn to the security of gilts: if held to maturity, they come with the Government’s commitment to repay investors in full.

That commitment has stood since gilts first appeared in the 1600s. And right now, there is another attraction for income-focused investors: gilt yields are offering returns that sit above inflation.

The yields on gilts rise when their prices come under pressure from higher inflation, interest rates, political upheaval, or the superior desirability of shares. 

You may be surprised by the hedge funds’ insouciance. After all, before entering No 10 Andy Burnham said Britain should ‘get beyond this thing of being in hock to the bond markets’. 

The remark caused five-year yields to spike above 5 per cent. The 10-year gilt yield went up to 5.04 per cent.

The Budget on October 28 may provoke another yield surge if the Chancellor John Healey – in his first Budget – unveils jaw-dropping spending proposals. 

Yet it is not just hedge funds who are keen on gilts at present. Ben Yearsley of Fairview Investing says: ‘I think gilts are a great idea for a portion of your wealth right now, whatever you may think about Burnham’s plans.’

He continues: ‘Why wouldn’t you when you can get 4.5 per cent on a five-year gilt, giving you a real return after inflation, and more than 5pc on a ten-year one. There are also the tax breaks.’

Richard Carter, head of fixed interest research at wealth manager Quilter Cheviot, suggests that it’s wise to be wary of hedge fund managers’ pronouncements.

He says: ‘Hedge funds are selling AI stocks to de-risk their holdings, but they are also famously opaque and secretive about their strategies, suggesting they may not see gilts as a long-term opportunity.

‘For retail investors, however, short-term gilts with upcoming maturities continue to look attractive, given the yields and the tax-free income.’

Against this background, you may now be thinking that gilts are neither tedious nor fraught with jeopardy, so here’s our guide to getting some bond action.

Why gilts have shone again

The change of heart on gilts is the result of a shift in sentiment which could mean that gilt yields fall slightly this year. In the markets, the new global focus of anxiety is interest rate policy in Japan and the US. In the UK, rises in interest rates now seem less likely than before. 

The jobs market is weak and inflation has not been pushed up as far as feared by steeper oil prices arising from the Middle East conflict. Meanwhile, the anxiety over tech titans’ willingness to splash out billions on AI is accompanied by worries that a slowdown in this spree would cause growth to slacken everywhere. 

Aaron Hussein, global market strategist at JP Morgan Asset Management, suggests that ‘government bonds are the best hedge or protection against such an eventuality.’

The S&P 500 US index may be up 13 per cent this year and the FTSE 100 8 per cent higher. 

But Hussein says investors should still be aware that ‘the ground beneath them tends to be less solid than it appears.’ 

The money-back promise of gilts

Gilts come in different maturities. ‘Short-dated’ gilts run from 0 to seven years; ‘medium-dated’ from seven to 15 years and ‘long-dated’ from 15 to 50 years. 

UK Treasury gilts pay a taxable fixed rate of interest or ‘coupon’ and offer repayment at maturity at the par value of £100 per unit, whether you have paid less or more than this. No government has ever defaulted on this obligation. 

The same money promise applies to UK Treasury Bills (UK T-Bills), which are known as ‘zero-coupon bonds’, as there is no interest. 

The whole of the return comes at maturity. Broker Interactive Investor cites the example of a six-month T-Bill issued at £97.50. 

The return would be the percentage gain between £97.50 and £100: 2.65 per cent. On an annualised basis, this equates to a 5.12 per cent yield.

The possibility of tax increases in the Budget makes the gilt tax breaks even more alluring. The interest on gilts is taxable unless they have been stashed into an Individual Savings Account (Isa). But if you buy a gilt and hold it until maturity, any gain is free of capital gains tax.

As Sarah Coles of investment platform AJ Bell points out, this highlights the appeal of very low coupon gilts issued during the pandemic when interest rates were close to zero, such as the Treasury 01.25pc January 31 2028.

The current price of this gilt, issued in June 2020, is £94.48. The ‘running’ or current yield may be an insignificant 0.12pc, but you will receive back £100 per unit on January 31 2028.

This means that the ‘yield to maturity’ – based on holding the gilt until that date – is 4.05 per cent. This represents a more than decent tax-free profit.

NatWest’s digital arm First Active offers 4.5 per cent. After savings tax this is worth 3.6 per cent, 2.7 per cent and 2.5 per cent respectively to a basic rate, higher rate and additional rate taxpayer. Savings tax rates will be increased by 2 per cent next April.

How you can take a gilt trip

You can buy through the Debt Management Office (DMO), the Treasury agency that issues gilts.

But using a platform – AJ Bell, Bestinvest, Hargreaves Lansdown or Interactive Investor – allows you to scroll through the 90 or so issues available, comparing prices, coupons and yields.

Caution is required. You may be intrigued by the 5.7 per cent yield on the Treasury 5.375 per cent 31/10/2056 Gilt. 

Yet much can happen in 30 years. An exchange traded fund (ETF) like the iShares Core UK Gilts or the Vanguard UK Gilt is an uncomplicated route into the sector.

Other options giving exposure to different time periods include the iShares UK Gilts 0-5 Year or Invesco UK GILT 15+ Year.

But in a fund you do not benefit from the capital gains tax exemption. 

Build yourself a gilt-edged ladder

Many gilt fans, particularly those who are retired, use a ladder principle.

This involves constructing a selection of low or zero-coupon gilts which trade below £100 and whose maturity dates match your future requirements. Like the rungs on a ladder, in fact.

You can budget for paying off a mortgage, or a special holiday. About 90 per cent of your regular inflows could be tax-free.

A level of administration is involved, of course, and you are also foregoing the chance for a slice of your portfolio to possibly appreciate in a soaraway share.

But diversification tends to come at some cost and in return you will be enjoying those generous yields and that money-back commitment.