Should you join the flight to bonds?

If you can lock in near-6% income on a bond portfolio, why expose yourself to the risk of a nasty stock market sell-off ? A growing number of ordinary UK investors are concluding just that, with Hargreaves Lansdown reporting a 38% year-on-year rise in the number of users holding individual gilts – UK government bonds.

The great government bond yield blow-out has been most prominent in long-duration instruments such as the 30-year gilt, which now yields 5.94%. But don’t let that lure you in. As James Baxter of Tideway Wealth notes, the government has avoided new issuance at such eye-watering rates.

Instead, you would have to buy a gilt that was issued a few years ago at a lower coupon and that is now trading at a discount to the par value. While the mathematics are slightly complicated, the takeaway is that a chunk of that tasty 6% return comes as a capital gain when the bond redeems at par value, say in 2055. Most of us will be long in the tooth by then.

While the state of the public finances might lead you to think that the UK is at risk of default, that isn’t a realistic prospect; the Bank of England can always print more pounds. Instead, the real dangers for bond buyers are interest-rate risk (higher rates tank bond valuations in the secondary market) and the risk of inflation that erodes the real value of the fixed income.

Are index-linked gilts (linkers) a solution to the risk posed by inflation? Probably not, says Christian Mayes for Morningstar. Linkers tend to have longer maturities than nominal gilts, leaving them more sensitive to higher interest rates. Indeed, linkers got crushed in 2022 because the damage from higher interest rates outweighed the benefits of built-in inflation protection.

A niche strategy for bonds

The renewed popularity of gilts rests in part on a rather niche tax strategy. While coupon payments are subject to tax outside an individual savings account (ISA), gilts are exempt from capital gains tax (CGT). That makes short-dated bonds trading at a steep discount to par attractive. Anna Macdonald of Hargreaves Lansdown highlights a 0.125% coupon bond currently trading for £94.78 and maturing in January 2028. That gives a mostly tax-free yield to maturity of 4.2%. For higher-rate taxpayers who have already exhausted their other allowances, such gilts are a low-risk place to put surplus cash. An understandable impulse, given all the talk of stock market bubbles.

But there are opportunity costs. Avid gilt buyers may be passing up better opportunities in the stubbornly cheap UK stock market. True, for income-seekers the FTSE 100’s 3% dividend yield is less appealing than the ten-year gilt. But at 7.4%, the earnings yield (the inverse of the price-to-earnings ratio) comfortably outstrips the ten-year gilt, notes Russ Mould in The Telegraph. Stocks still look the better value proposition.

Yes, markets can crash. But equities also offer the opportunity for capital gains and, perhaps crucially in the current setup, a degree of protection against inflation.

This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.