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. 

Are gilts a good investment? 

Gilts are appealing to some investors as they offer a pre-determined return with low risk if held for their full term. Government bonds are typically viewed as the ‘safest’ area of fixed income investments and gilts have a low credit risk, reflecting the fact that interest and capital repayment are guaranteed by the British government.  

The price of a gilt in the market tends to change over time, mostly in reaction to interest rates and the inflation outlook. 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 date. 

As we have seen recently, fiscal credibility from the government is a significant factor too. If investors worry that spending and borrowing could get out of control, and that national debt will become unmanageable and lead to inflation or currency devaluation, then they will demand a higher yield and a lower price,  

The ideal conditions for investing in gilts is if inflation and interest rates are forecast to fall more than previously expected, or not rise by as much as expected, over the term. Conversely, if inflation and interest rates are suddenly anticipated to ramp up, that’s bad news for gilt investment as investors demand a higher return and prices fall. 

Recently, there has been significant volatility in the gilt market. Political issues have added to global inflationary pressures from the higher energy prices that have resulted from the Iran conflict. However, the selloff has partially reversed on better news emanating from the Middle East, as well as comments from Prime Ministerial rival Andy Burnham who pledged to reject any changes to the UK’s ‘fiscal rules’.  

Markets have scaled back expectations for further interest rate hikes from the Bank of England given the weakness in the UK economy and some more benign inflation data. Although it is possible that high energy costs could still embed secondary inflationary effects and maintain downward pressure on gilt prices, at least in the near term. 

What is a gilt fund?

Gilt mutual 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 smaller.

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 UK government bonds 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, and returns therefore skewed to capital rather than income, they can be useful for higher and additional-rate taxpayers in particular 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 income 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 as well as other fixed income investments such as corporate bond funds. 

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 keeps rates high, gilts could still provide a respectable return given income yields above 4% across all maturities. Meanwhile, most longer dated gilts offer more than 5% at the time of writing, peaking at 5.5% for the 30-year gilt. 

However, should inflation remain significantly above the bank’s 2% target (keeping interest rates high too) for a long while 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 greater 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. The bond market’s reaction to economic growth, inflation, and government spending plans can be sudden and consequential, which is why Chancellors, and Prime Ministers, 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 30% of the fund is in bonds with maturities of more than 15 years, so it will be 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 70 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. 

Alternatively, for investors looking to minimise the risk of interest rate sensitivity a fund that focuses on short-dated gilts such as iShares UK Gilts 0-5 Yr UCITS ETF could be worth considering.