UK Gilts and Forward guidance: some observations on tax efficiency
by George Hatjoullis
UK gilt yields have risen since Mr Carney’s forward guidance. Sterling has also strengthened. This is probably not what Mr Carney had hoped. Indeed, he explicitly stated that he thought the market was exaggerating the likely (higher) path of interest rates. It is now ‘exaggerating’ even more so. You can guide the market but it will form its own opinion.
In contrast bank deposit rates continue to fall. The banks are flush with (cheap) cash from the BoE Funding-for-Lending scheme and do not need ours. Moreover, attractive lending opportunities are not that plentiful. There is constant pressure on banks to hold more equity capital and so they are very sensitive to the risk of their investments.
The required level of equity depends on the size of the balance sheet. However, not all assets are deemed equal risk. It is the risk weighted balance sheet that is relevant to the capital need.The riskier the investment the higher the capital charge. Gilts are deemed risk-free and involve no capital charge. The higher that gilt yields rise the more interesting they become to banks.
The rise in yields is also very good news for pensioners. Annuity rates are linked to gilt yields. The higher the gilt yield then, other things being equal, the higher should be annuity rates (or the profits of annuity providers). It is a matter of some importance to pensioners or soon-to-be pensioners whether the market response to the forward guidance is correct. The key variables are inflation and unemployment and both are subject to wider macro-economic developments. The market is saying things look pretty good and will most likely get better. The market is not infallible but its guess is usually the best one. What is the significance of all this?
There is probably a limit to how far long dated gilts will rise. As noted, banks may find such assets attractive and as annuity rates pick up, more pensioners will lock into annuities. This will result in correspondingly higher demand for gilts. There will come a point when buying gilts directly or indirectly via annuities will make sense. However, I suspect not yet.
[As an aside here I should note that the practice of moving into bonds and waiting to buy an annuity is not very sensible as you have effectively locked into the annuity rates by buying bonds. If yields rise, improving your annuity possibilities, the value of your fund will fall. If you want to wait to buy it makes more sense to be in cash]
Those looking for an income outside of a pension plan or ISA should be watching the gilt market closely. The rise in yields is pushing some nominal gilts below par (100). This creates interesting opportunities. If you hold gilts directly (not gilt strips) and then sell, you will not generate a potential capital gains tax charge. If you hold a collective vehicle (e.g. unit trust) and then sell units then you will generate a potential capital gains tax charge. It is best to hold gilts directly for tax efficiency. Now here comes the interesting bit. If you invest in a gilt trading below 100, then you effectively convert some of your income tax liability on the coupon into a zero capital gains tax liability.
All conventional gilts mature at 100. If you buy one for, say, 90 then the 10 points it will accrue towards 100 are deemed capital gain and not taxable. Only the coupon is taxed as income. The yield that you see quoted is of course the yield to maturity and this combines the coupon with the maturity value. Investing in gilts trading at a deep discount to par is highly tax efficient. The situation for index linked gilts is a little more complicated but the same principles apply. Only strips do not benefit as all accrual is deemed to be income.
The very low gilt yields of recent years has made such tax efficient investment difficult outside of an ISA or a pension plan because most gilts have been trading above par. The rise in yields has created new possibilities. Not only is it making higher income possible but it is also making it possible at a lower effective tax rate. At the moment there are only a few issues trading below par. If yields rise far enough there should be more. How far will gilt yields rise?
It is impossible to say as there are many forces at play. Natural demand will come in as yields rise and the government is busy trying to limit the need to borrow. However, UK inflation has been sticky downwards despite negative real wage growth. The economy is picking up steadily and looks set to continue. My reference is 3.25% Treasury Gilt 2044 (chart above). The price is circa 92 and the yield circa 3.7%. The yield has already risen from a low of 3%. At 4% it is going to start looking very interesting to income investors that are happy to lock in for 31 years. Most will be looking for a shorter dated stock.
Those interested in a little DIY income investment in gilts will find the Debt Management Office site invaluable (http://bit.ly/16Tp27P). It is also possible to trade gilts through the DMO. However, it is a clumsy process if you want to finesse a particular yield. Gilts cannot be traded online. Phone trading is the norm.