How to invest in UK government bonds with a gilt fund or ETF

Rising interest rates have opened up opportunities for meaningful returns from UK government bonds or ‘gilts’. While these were an unattractive option when interest rates were rock bottom, they are now appealing to some investors as they offer a pre-determined return with low risk if held for their full term.

A gilt is a bond issued by the United Kingdom government to finance public spending. Their name is a shortened version of their full title ‘gilt edged security’, which refers to their original paper form of certificates with gilded edges.

As a holder you get regular interest payments (known as the ‘coupon’) and the original amount lent repaid when the bond ‘matures’ at a set date. Individual gilts can be issued for any length of time from three months to 30 years, or even longer. Investors can hold on to them until they mature, or they can buy and sell them on the market, like company shares.

Government bonds are typically viewed as the ‘safest’ type of bond and gilts have a very high credit rating, reflecting the fact that interest and capital repayment is guaranteed by the British government, which has never failed to make payments. However, the price of a gilt in the market tends to change over time, mostly in reaction to interest rates. If they go up, a gilt’s price usually falls, which means the available yield – the annual return an investor can expect for holding a gilt – rises. This also means you can make a capital loss on a gilt if you buy and then sell before maturity.

There’s more on how bonds in general, including gilts, work here.

What is a gilt fund?

Gilt funds or gilt ETFs can represent an alternative to buying individual gilts. There are several advantages in doing so.

You’ll be diversifying across lots of different gilts with different maturities, making it an ongoing investment rather than one that expires at a certain date. The minimum investment size is also much smaller. It’s also possible to buy and sell online, which isn’t normally possible with individual gilts, plus as an alternative you can easily access overseas government bonds too such as US treasuries.

Bond tracker funds and ETFs (Exchange-Traded Funds) can be issuer or geography specific, as well as broadly or narrowly focused on maturity. For instance, some exclusively invest in shorter dated bonds (maturing in the next 12 months), others only the longer dated issues (maturing between 10 and 30 years into the future). The longer dated a bond the more sensitive it tends to be to future interest rate expectations, so they can be volatile when things shift suddenly. There are also actively managed gilt and broader bond funds, which aim to outperform a particular benchmark index.

Read more: Why funds are a great investment shortcut

Are gilt funds tax free?

Individual gilts are free from capital gains tax (CGT), which means you do not have to pay tax on any profit you make when you sell a gilt or it is redeemed. With many gilts trading below their redemption value they can be useful for higher and additional-rate taxpayers who pay CGT at 24%.

However, this capital gains tax advantage does not apply when they are held within an ETF or fund. If you make a capital gain outside a tax-efficient account, such as an Individual Savings Account (ISA) or Self-Invested Personal Pension (SIPP), then tax may be payable. Funds also incur annual management charges and expenses, which detracts from returns, so if you are investing larger sums of money outside of a tax-efficient account then you could consider low yielding individual gilts that mainly provide capital return rather than income.

The interest from individual gilts and gilt funds or gilt and bond ETFs is also taxable when held outside an ISA or SIPP. If your interest from all sources exceeds the personal savings allowance in a tax year, and your overall income exceeds the income tax personal allowance, then you will have to pay tax on your interest returns from a gilt fund or ETF.

Are gilt funds safe?

Investing in gilts isn’t right for everyone. While gilts are as seen as ‘safe’ their returns are generally pedestrian compared with other areas such as the stock market over the long term. In addition, your capital is at risk, and they can suffer badly when inflation and interest rate expectations suddenly rise, especially longer dated gilts.

This is what has happened in recent years as inflation ramped up much faster than widely expected and took longer to fall. However, from this juncture there are good arguments for holding bonds and gilts as balancing assets in a diversified portfolio, and the asset class stands to benefit from an environment where interest rates fall more than widely anticipated.

Is it the right time to invest in gilt funds?

There could be some value in UK gilts presently if UK interest rates are cut faster than markets are pencilling in. Even if inflation remains sticky and the Bank of England keep rates high, gilts could still provide a respectable return given income yields around or above 4% across all maturities.

However, should inflation rebound and remain significantly above the bank’s 2% target (keeping interest rates high too) then gilts, and gilt funds, would likely struggle. The answer to the question “why are gilt funds falling?” is usually one of two things (or a combination): Longer-term inflation and interest rate expectations rising or confidence in the longer-term sustainability of the UK’s government debt waning.

How to invest in gilt funds

Which gilt fund is best for you generally depends on the amount and type of risk you want to take on. Some specialise in longer dated gilts and have significant sensitivity to future inflation and interest rate expectations and can work well when these subside. They are also attuned to the sustainability of the UK’s longer term fiscal policy and whether it looks sustainable. The bond market reaction to economic growth, inflation, and government spending plans can be sudden and consequential, which is why Chancellors like to keep them onside.

In contrast, shorter term gilt funds tend to have much lower sensitivity to these longer-term factors and are more influenced by short term central bank policy – essentially the direction of interest rates over their lifetime. General gilt funds investing across the spectrum of duration tend to sit between the two.

You can invest in gilt funds and gilt ETFs via an online investing platform such as Charles Stanley Direct. One example of a general UK gilt ETF is Amundi UK Government Bond UCITS ETF, which is on our Preferred List of fund ideas for new investment. This is a passive investment or tracker as opposed to an active investment fund, and it’s typically an area where active fund management can only be expected to achieve a small margin of improved return, if any.

This ETF is designed to replicate the total return of the FTSE Actuaries UK Conventional Gilts All Stocks Index, which is intended to reflect the breadth of the UK gilt market. Around 40% of the fund is in bonds with maturities of more than 15 years, so it will be highly sensitive to interest rate and inflation expectations. If these rise, then the capital value of the fund is at risk.

The ETF fully replicates the index by tracking approximately 40 gilts. It features competitive charges and, typically, small trading spreads. The index is rebalanced monthly, and income is distributed to investors on a six-monthly basis.

Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.