Gilts are good diversification assets

Gilts are good diversification assets

The current context of geopolitical uncertainty and weekly upheaval is now so self-evident, it is barely mentioned. Even the banking fraternity has arrived at the point of acceptance.

Sir Mark Tucker, chairman of HSBC recently said ‘globalisation may have now run its course…..trade tensions pose a potential risk to global growth….the world is undergoing a period of deep and profound change’.

US tariffs, levied on a unilateral basis, (without regard for WTO rules) on overseas goods from many of its trading partners have unsettled global equities and caused funds to flow into fixed income investments.

The new realities are causing weak consumer and business confidence data and lower GDP growth expectations for 2025. Furthermore, the US tariffs (China 34%, Taiwan 32%, India 26%, Japan 24%) are likely to hit the BRICS and the world’s smaller economies very hard denting activity in previously emerging economies.

Gilt edged yields are providing elevated short, medium, long term nominal returns. This is due to the UK government’s significant and ongoing borrowing requirements. This means primary issuance (issue of new gilts for government funding) will remain high.

At present yields are over 5% for long gilts with over 20 years to maturity. The yield curve is upwards sloping, suggesting investors are requiring compensation for taking longer term inflation risks.

source: www.bloomberg.com

Over the last 12 months the Bank of England has lowered the Bank Rate on three occasions, each by 0.25% taking the rate from 5.25% to 4.50%. The Monetary Policy Committee’s approach has been gradual and was delayed by the events of 2024, notably the surprise July election and October budget.

However, despite the recent series of rate cuts and investors’ expectations that interest rates will be cut by another 0.6%- 0.75% by the end of 2025, the yields offered by the gilt market have risen. This does not normally happen. Usually yields fall when the Bank Rate, i.e. the cash rate, falls.

There are various explanations as to why yields have remained so high. These include persistent concerns over inflation, and investors remaining alert to high levels of gilt issuance from the UK government. That said, the expectation is gilt yields will eventually decline as rates move further down.

It is worth recalling that gilts offer an attractive alternative to cash or term deposits and as obligations of the UK government should be considered risk free from the point of view of interest and return of capital. As government securities they carry a AA sovereign rating.

Gilt yields in the 4%-5.2% area offer attractive nominal returns compared to the 13 year period of sub 1% interest rates post the 2008/2009 financial crisis ie. recent financial history. More importantly, yields are attractive relative to other asset markets including UK equities currently offering around 3.5% and UK property now paying c. 2.5%.

The expectation is interest rates could well remain at similar levels i.e. 4%- 4.5% for the next five years. The shape of the yield curve is upwards sloping meaning investors can lock in high yields for well over a decade.

Attractive for higher rate tax-payers

Both income and capital gains on gilts are tax free inside an ISA. So it worth having a high coupon medium /long dated gilt inside an ISA.

Outside an ISA, gilts’ income is taxable (beyond the Personal Savings Allowance) but capital gain on gilts remain tax free. It is better therefore to house a low income gilt in a conventional investment account.

There are advantages in structuring a gilt portfolio to minimize income (due to investing in low coupon gilts) whilst obtaining most of the return as tax free capital gains.

For example, the Treasury gilt 0.5% 2029 (maturing in 31 January 2029) currently priced at 88.1 and yielding 3.866%.

When adjusted for basic rate taxpayers, the tax equivalent yield approximates 4.83% whilst for higher rate payers the yield rises to 6.44% and to 7.029% for additional rate taxpayers. The tax equivalent yield is effectively a yield adjusted for the tax bracket of the holder.

Gilts popularity surges

According to Hargreaves Lansdown, 32% more clients held gilts in their accounts at the end of February 2025 v February 2024. The data below might explain the reason for their popularity. Returns are close to their highest levels for the last ten years for 5, 7, 10 and 30 year gilts.

Source: www.worldgovernmentbonds.com

The data also shows yields coming off their highs a bit, a trend that should continue given the expected rate trajectory.

Conclusion

Gilts yields offer attractive fixed income investments that could appreciate from current levels if inflation subside or as relative safe haven investments, if as expected, high levels of uncertainty persist around global GDP growth.

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