DIY investors go on a bond buying spree

• Five of the ten most popular investments made by AJ Bell’s DIY investors in September were government bonds
• Investors are using gilts as a tax-efficient cash proxy
• The anticipated peak of the interest rate cycle has likely driven demand
• Money market funds also prove popular, especially in ISAs

Laith Khalaf, head of investment analysis at AJ Bell, comments:

“DIY investors went on a bit of a bond buying spree in September, loading up their portfolios with gilts. Five of the ten most popular investments on the AJ Bell platform in September were government bonds, as measured by net cash flows, and this is a trend we’ve seen across the summer too. The number of individual investors buying gilts is relatively small, but they are dropping chunky sums into these bonds, so cash flows into these instruments have been strong. The average amount invested by individual investors in the five most popular gilts in September was £129,000.”

Most popular investments by DIY investors on the AJ Bell platform in September based on net £ flows

Source: AJ Bell, data from 1-30 September 2023, not including AJ Bell funds

What’s behind the gilt rush?

“A number of factors explain the recent gilt rush. Government bond yields are very tempting at current prices, particularly against a backdrop of the exceptionally low yields on offer in the decade following the financial crisis. Today’s rates are more normal by historical standards, but after the era of ultra-loose monetary policy, bond investors can be forgiven for feeling as if they’ve never had it so good. Like Morlocks emerging from the subterranean gloom, they find themselves frolicking in the sunny uplands of a world where yields are plentiful.

“As inflation has moderated and the Bank of England has taken its foot off the brake with a pause in interest rate hikes, short term yields have also dipped over the summer. This has probably prompted some investors to take action to lock in yields in case they fall further. There has of course been a recent sell-off in the gilt market, but this has mainly been felt in longer dated bonds, where yields are breaking fresh highs (see chart below). DIY investors have so far been more interested in the short-dated end of the market, and here yields are actually coming down off a recent peak. The latest bond downturn has been sparked by a fear that rates may stay higher for longer, and that carries greater significance for longer dated bonds, which are more sensitive to interest rate changes too.”

Source: Refinitiv

The tax attraction of government bonds

“Gilts have been particularly popular purchases in dealing accounts with AJ Bell rather than SIPPs or ISAs. Combined with the fact that the most popular bonds are short-dated and with low coupons, this suggests investors are buying gilts as an alternative to cash to save tax. Gilts aren’t subject to capital gains tax, and so those bonds with low coupons which rely on a high capital return will be liable to very little taxation, just income tax on the small interest received (see worked example below). This compares to a savings account where the interest might be taxable at 20%, 40% or 45%. So if the yields are similar, gilts are more tax efficient for those who have breached their personal savings allowance (£1,000 for basic rate taxpayers, £500 for higher rate taxpayers and £0 for top rate taxpayers). Given prevailing cash rates and yields, it’s easy to see why some savers are indulging in gilty pleasures.”

Cash savings rates versus gilt yields

*Assuming £500 Personal Savings Allowance has been used up

**The proportion of the yield which is taxable depends on the bond price and interest payments, but it’s currently possible to find short-dated gilts with very low interest payments where almost all of the return is due from capital gains, which are not taxable. Yields assume the bond is held to maturity. The gilt yield used for comparison against easy access rates is the 3 month gilt yield, so it is not a direct like-for-like comparison as investors would need to wait three months to be guaranteed their capital back.

Gilt taxation: an example

Suppose there is a government bond which has a coupon of 0.5%, with a face value of £100 which will be paid to the holder on maturity in precisely one year’s time. You can currently buy this bond in the market at a price of £95.

As the coupon always relates to the face value of the bond, the interest payable to the bond purchaser will be 0.53% (£0.50 / £95) per annum. This 0.53% is taxable as interest. So it could be worth 0.42% to a basic rate taxpayer, 0.32% to a higher rate taxpayer or 0.29% to a higher rate taxpayer (if they have used up their Personal Savings Allowance).

However the lion’s share of the total return from this bond is coming from the capital appreciation from the current market price of £95 to the maturity value of £100 in one year’s time. This adds a further 5.3% (£100 / £95) to the total yield of the bond, but seeing as gilts are exempt from capital gains tax, the investor can receive this return in its entirety with no tax to pay.

Security and costs of buying gilts

“Gilts are also backed by the government, so you are guaranteed your money back at maturity, in the same way as NS&I savings, except in the very unlikely scenario where the UK government defaults on its debt. This may well also be appealing to cash savers who want to park more cash than the £85,000 covered by the Financial Services Compensation Scheme in the event a bank goes bust. Unlike fixed rate cash accounts you can also get access to your money instantly by selling gilts, though this will be at a market price which could mean selling at a loss. Nonetheless you can still get immediate access to your capital, which can be useful for those who may want to enter the stock market quickly if there is a dip, or those who are holding money ready for a house purchase at an unknown point in time.

“There are costs to buying gilts. In terms of transaction charges there is no stamp duty, but there are stockbroking charges to pay, though nowadays these are normally very modest flat rate fees. There is also a bid-offer spread on gilts, which is particularly relevant if you might wish to sell before maturity. You will also usually pay custody or platform charges for ongoing administration of your gilt holdings. Gilts can also be difficult to get your head around, so this is an area which is probably best reserved for experienced investors, or those who are willing to commit some time to understand how government bonds work.”

Money market funds prove popular in ISAs

“Outside of gilts it’s interesting to note that money market funds have also been popular with ISA investors (highlighted in the table below). The interest from these funds is fully taxable, unless held in a SIPP or ISA, so demand for these products suggests investors are currently prizing liquidity and enjoying the fact that they can actually get a reasonable return without taking a great deal of investment risk. Money market funds have been particularly popular within ISAs, where the interest is tax-free. The most popular investments in an ISA in September also include a gilt with a 5% coupon. This interest would be taxable if held outside an ISA, but the ISA wrapper means it can be received tax-free, so investors are definitely boxing smart with their government bond purchases. It’s also notable that two insurance companies, Phoenix and Legal and General, have also attracted a fair amount of investment. These stocks are carrying prospective yields of 10% and 8.9% respectively, so even here it seems investors are enjoying the income boom.”

Most popular investments by DIY investors in the AJ Bell ISA in September based on net £ flows

Source: AJ Bell, data from 1-30 September 2023, not including AJ Bell funds