Tax, Inflation, and Yield

by George Hatjoullis

The recent pick up in inflation has been met by central bankers and politicians with a certain amount of relief. Deflation has many characteristics which politicians in particular dislike. It impacts tax revenues negatively. Inflation allows a surreptitious increase in tax revenue known as ‘fiscal drag’. As inflation picks up, nominal values adjust upwards, and so even with constant tax rates, tax revenues rise. If your pay goes up because of an inflation adjustment and the rise places you in a higher tax bracket then you are clearly worse off after tax. In effect, tax revenues are automatically inflation-linked whilst government expenditures are not, so inflation increases the net tax take without any change in rates. Nice!

Many investors also seem to welcome the rise in inflation, even those that typically hold nominal assets (like cash in the bank). This is because it raises the prospect of a rise in interest rates. This is of course somewhat naive as it is a rise in real interest rates that investors should welcome not simply nominal interest rates. If inflation and nominal interest rates increase at the same rate, the real interest rate does not change. However, the investor may be worse off because of fiscal drag. The investor may be dragged into a higher tax bracket because nominal income has increased. This can create some interesting investment quirks.

Gilts are a popular low default-risk asset for investors seeking a stable income and security of principal. Fixed coupon gilts pay a coupon twice yearly up to a fixed maturity date. They are issued in nominal amounts of £100 (which is what you get back at maturity) but on any day will trade above or below 100 depending on how bond yields are moving. If bond yields rise a lot, say because inflation is rising, then prices will fall and possibly a long way below the nominal or par value. During the recent period of very low yields prices have moved a long way above par. The return from a gilt can be looked at in two ways; the running yield and the yield to maturity (ytm).

The running yield is simply the annual coupon payment divided by what you paid for the bond. The ytm is a bit more complicated but think of it as the annual interest rate or return if you hold the bond until it matures. One of the quirky aspects of such gilts is that whilst the coupon is taxable as income, any capital gain or loss from buying and selling the gilt incurs no capital gain tax. This means that which issues it makes sense to buy depends on your tax bracket. The effective after-tax ytm on each bond may be quite different. In a rising inflation and  yield environment this creates problems and opportunities.

The Debt Management Office website offers closing prices on all gilts. Consider two issues. The UKT 1.5% 2047 and the UKT 4.25% 2049. The running yield on the UKT1.5 is 1.66% and the running yield on the UKT4.25 is 2.71%. The ytm on the respective bonds is 1.92% and 1.88%. The prices of the respective bonds are 90.47 and 157.11. They will both get £100 back at maturity. The buyer of the UKT4.25 makes a loss at maturity but has effectively been repaid every year in a higher coupon and running yield. In a zero tax world which bond one chooses rather depends upon needs and circumstances in relation to cash flow. But the world is not zero tax.

What if the investor is a 40% tax payer at the margin. The after-tax running yield on the two bonds is now 0.99% and 1.62% respectively but the after-tax ytm is 1.28% and 0.61%. The low coupon bond offers a much better return to maturity. The reason is that £9.53 per bond is returned at maturity tax free. The high coupon bond effectively has £57.11 returned over the 32.5 year period each year and is taxed at 40%. A 40% tax payer is thus well advised to avoid bonds trading above par and seek out bonds trading below par. The interesting thing is that as inflation and bond yields rise, there will be more such bonds (as prices fall) and the discount to par will get deeper and deeper creating even greater tax advantage for the high rate tax payer. The deeper the discount the more of the bond income is returned at maturity free of any tax.

The latest CPI reading is 2.9%. The highest one year fixed rate interest rate I have been able to find is 1.7% (Masthaven) so we are looking at -1.2% real, at best. The latest RPI is 3.7%. This index is discontinued as an inflation measure but is still used as an index in index-linked gilt calculations, on Index-linked certificates, and many pension and insurance contracts. If you have a NS&I Index-linked certificate you can roll it (no new certificates are being issued) at essentially the RPI rate, which compared to the CPI gives you, bizarrely, a positive real yield. Similarly, index-linked gilts which post real yields based on RPI are, compared to CPI, less negative than they might seem. If your pension is going up by the RPI then you are getting real pension increases. Of course, this presupposes that CPI is a better inflation measure than RPI.

The period of deflation and low-interest rates has been good for the wealthy. Not only has it inflated nominal asset values but it has enabled the wealthy to hold wealth in nominal assets (like cash) without the risk of surreptitious inflation taxes. A jump in inflation with a lagged jump in interest rates is particularly bad for wealth. However, even if real rates are stable, fiscal drag will hurt nominal incomes. The tax treatment of gilts and the CPI/RPI difference creates some interesting opportunities for the watchful.

Postscript

I used the Candid Money yield calculator and adjusted coupons down by 40% to obtain after-tax yields.

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