Are gilts an efficient alternative to cash?
Summary
If you hold substantial cash balances and are seeking to maximise your net returns with very low risk, you may benefit from purchasing gilts.
Interest rates have increased substantially since 2022 and the shift to higher interest rates means you may be incurring significant tax liabilities on interest from your cash deposits.
As capital gains on gilts are exempt from tax, some gilts could provide higher net returns (i.e., after tax and fees) than are available from cash, especially for higher or additional rate taxpayers.
A good independent wealth adviser will advise you on how to optimise your savings in the context of your broader financial planning strategy.
Cash
Conventionally, to fund a short-term (e.g., less than two years) cost you might hold cash rather than risk capital.
At present, if you shop around, you can earn around 5% pa interest on cash deposits. However, interest on cash is subject to income tax at your marginal rate, and you may lose up to 45%[i] [ii] of the interest to income tax, resulting in a much lower net yield, as outlined in the following table.
One way to manage the tax liability is to save through cash ISAs, but contributions are limited to £20,000 per person per year, and you may already be using your ISAs to manage tax liabilities on your longer-term investments.
Gilts
Gilts are UK Government debt, issued by HM Treasury, and listed on the London Stock Exchange. The price of ‘a gilt’ is typically quoted per unit of £100 nominal value. Though you can buy any amount.
By buying ‘a gilt’ you are effectively lending to the UK Government, and you will receive £100 (the nominal value) back at a specified maturity date, plus a fixed coupon (interest) payment every 6 months. This creates a guaranteed[iii] yield if the gilt is held to maturity (the 'yield to maturity').
Taxation
The half-yearly coupon payments from gilts are subject to income tax at the owner’s marginal rate.
Any capital gain from a gilt are exempt from capital gains tax[iv].
A result of the change from very low interest rates to higher interest rates is that many of the gilts issued by the UK government over the past 15 years were issued with very low coupons. However, the increase in interest rates has caused gilt yields to increase and the gilt prices to fall.
This means, for some gilts, most of the yield to redemption is from tax-exempt capital gains. Depending on your situation the net yields on low-coupon gilts could be significantly higher than for cash.
By way of example, the table below shows the gross and net yields on two short-term low-coupon and a higher-coupon gilt, highlighting the importance of picking the right gilt for you [v].
Index-linked gilts
Above we have focused on conventional gilts, which have a have a fixed coupon and maturity value of £100. It is also possible to purchase indexed-linked gilts, where the price at maturity and the coupon both increase with inflation, as measured by the retail prices index (yes, RPI and not CPI). All index-linked gilts currently have yields to redemption exceeding RPI.
Purchasing gilts
Most stockbroking accounts and many investment platforms[vi] enable you to purchase gilts directly.
Other considerations
Other uses for gilts
In addition to being an alternative to cash for short-term savings, gilts can provide diversification and downside protection for longer-term investment portfolios, and you could consider holding longer duration gilts (as well as shorter duration gilts), for this purpose.
The same potential tax-efficiencies apply to longer duration gilts. Therefore, when you allocate the assets in your investment portfolio to the various types of investment account available to you (e.g., ISAs, pensions, taxable investment accounts, and offshore bonds accounts), you should consider the potential tax efficiency of gilts. For example, it may be better to utilise tax efficient pensions and ISAs to hold assets that are less tax efficient to hold directly.
Investor protection
Cash deposits are protected by the Financial Services Compensation Scheme up to a maximum of £85,000 per person, per banking group. Gilts are 100% guaranteed by the UK Government, therefore may negate the need to spread cash around multiple deposits.
Fees
A good fixed-fee adviser will advise you on your short-term savings as part of their ongoing service, so there should be little difference to your fee whether you hold cash or gilts. However, if your adviser charges a percentage of your ‘investable assets’ then you should check whether there will be extra fees, as these could negate the benefit. For example, if an adviser charges a 1% annual commission, this is equivalent to 20% tax on a 5% investment yield.
You should also consider the fee structure of the investment account you use to purchase the gilt.
Notes:
[i] Basic rate taxpayers receive a ‘personal savings allowance’ allowing them to receive up to £1,000 of interest and not pay tax on it. Higher rate taxpayers can receive up to £500 of interest, but the allowance is not available to additional rate taxpayers. Those with lower incomes may also be entitled to a starting rate of 0% on up to £5,000 of savings income over the personal allowance.
[ii] Traps in the UK tax system mean that the effective rate of income tax can be much higher than 45%. For example, if the interest from your cash balances increase your income to over £100,000, you could pay an effective rate of tax of 60% on your interest and lose access to free childcare. If this affects you, then holding low coupon gilts instead of cash could be even more efficient.
[iii] To the extent that the UK government can repay its liabilities. You should also note that while the redemption price of the gilt is fixed, the price in the period to redemption can vary, for example to reflect changes to interest rate expectations, and to the perceived creditworthiness of the UK Government.
[iv] Holding gilts through one of the various types of investment fund may not be as effective for short term savings, as the funds are likely to include higher coupon gilts that create higher income, and capital gains on investment funds are subject to capital gains tax (even if they only invest in gilts).
[v] The two gilts shown are not meant as recommendations, rather to highlight the potential differences in net yields to investors.
[vi] Investment platforms are account providers that offer access to a wide range of investments and usually offer personal pensions, ISAs, and taxable investment account. Some also offer access to offshore bond accounts.
General:
Before you invest in any investment, you should consider obtaining personalised advice from an independent financial adviser.
Any reference to legislation and tax is based on our understanding of UK law and HMRCs practice at the date of production. These may be subject to change in the future. Tax rates and reliefs may be altered.
You risk losing capital when you invest.
This article is meant as a summary only and we have simplified many of the areas for brevity.
Price, interest rate, and yield information are as of 29 July 2024.
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