How to achieve high tax equivalent risk free returns using government bonds.

UK and global government bonds have had a rough ride of late. To be fair, it’s not often in history that central banks raise rates from 0% to 5.25% in the space of 18 months.

The recent price falls however have exposed a specific tax driven investment opportunity.

It’s worth revisiting bond mechanics. A bond is an IOU to the government. You lend money today to the government today. In return it gives you a piece of paper saying it owes you. In ten years you give up the piece of paper and in return it gives you back your money . Every year in between it pays you a fixed amount of interest. During this time, the piece of paper can be bought and sold on an exchange every day.

Let’s look at a specific bond which the government issued a couple of years ago. This is the ticker-  UKT 0.25% 01/25

If you bought £100,000 of it in January 2021 and held it till January 2025, every year you would receive £250 pounds worth of interest (0.25% coupon) and you would get your £100,000 back then.

Today though nobody would pay £100,000 to receive £250 pounds every year when interest rates are at 5% plus .

Today they would pay £94,391 pounds for that bond. They would still receive £250 pounds every year but in January 2025 they would get £100,000. So they would receive £5,609 pounds extra cash in a year and a half.

 

This is equivalent to an annual yield of 4.78% . But here’s the thing. Almost all of this yield is tax free because the return is from the capital gain on the bond rather than the interest paid. And capital gains on bonds attract no tax.

For a 45% taxpayer, it’s the same as investing in a 15 month fixed deposit account paying 8.5%.

If you don’t need immediate access to your money, are a higher or additional rate taxpayer and have a time horizon of up to 10 years, have money outside of ISAS and pensions, this strategy makes lots of sense. You can create a portfolio of bonds with different maturities called a bond ladder. In this way you can diversify your maturities and duration and lock in yields for longer periods.

Its very low risk because it’s extremely unlikely that the UK government will default on its debt and  the central bank can buy government debt if necessary (and was  doing so since 2008 until recently).

The example above assumes that the bond is held until maturity – if sold before then you can lose money as there is no guarantee that you will receive the full amount you originally paid for the bond.

If you would like to explore investing in such a tax advantaged UK govt bond portfolio, please get in touch.

This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.

The value of investments may go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.

The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.

 

 

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