Are UK government bonds a good investment: In-depth guide to understanding UK gilts

Fixed income is a catch-all label for different types of bonds, including corporate or government bonds. Bonds are issued by countries, companies, and supranational organisations (such as the World Bank). Investors buy the bonds, receive an ongoing interest payment (or ‘coupon’) and then their money back at the end. Changes in interest rates can lead to fluctuations in bond prices, impacting potential capital gains for investors.

The level of the interest payment will depend on the perceived riskiness of the bond. If there is a high chance that the bond issuer might default on their payments, investors will require a higher coupon to persuade them to invest. Government bonds issued by the world’s largest economies – UK, US, Canada, Germany, or France, for example – are considered to be lower risk. When interest rates rise due to rising inflation, the prices of existing bonds usually fall, which can affect their attractiveness to new investors.

Investors can buy bonds directly, or can invest via collective funds, where an investment manager will create a portfolio of bonds to meet a specific objective or income target. While the risks of individual bonds will vary, fixed income is usually seen as a lower risk than stock market investment. Many investors choose to buy government bonds for their perceived safety and predictable returns.

What are UK Government Bonds?

UK government bonds, or ‘gilts’, are debt instruments issued by the UK government. This is how the UK government finances any additional borrowing it needs over and above the money it raises in taxation. The proceeds from the bonds may be used for day-to-day spending, such as public services, or for investment activity, such as building schools and hospitals.

UK government bonds will be issued with different maturity dates and may last from as little as one month to as long as 50 years. The maturity date will influence the coupon payment. In general, longer-dated bonds will have a higher coupon payment to compensate investors for the uncertainty on changing interest rates and inflation. However, this can vary at certain points in the economic cycle.

The interest rate paid on UK government bonds will be influenced by a number of factors:

• The prevailing interest rates from the Bank of England. Interest rates will change over time, depending on the level of inflationary pressures in the economy. Higher inflation will usually lead to higher interest rates, while an absence of inflationary pressures will usually cause interest rates to fall. There is a direct relationship between a country’s interest rates and the coupon on its government bonds.
• The perceived riskiness of the UK versus its peer group. This will depend on factors such as the level of UK indebtedness, the government’s spending plans, and its political situation. In practice, the riskiness of developed markets such as the UK doesn’t vary considerably, but there may be moments when it becomes important. Recent examples would be the current political upheaval in France and the Liz Truss ‘mini budget’ in September 2022.

Advantages of Investing in UK Government Bonds

1. Income
   With UK government bonds, investors know they will receive a specific income for a set period of time. If they buy a 5-year gilt with a coupon of 4.25%, they will receive 4.25% every year for five years. In this way, the income they receive is predictable and safe. The UK government has never defaulted on its debt*.

   This is different from cash and savings accounts, where the interest rate can rise or fall if the Bank of England changes interest rates. It is also different from dividends from companies, which are determined by the cash flow from a company’s operations and may vary over time.

2. Capital protection
   Investors can be assured that they will get their money back at the end when the bond matures. The UK government has always paid its bonds back in full. As such, UK government bonds are a compelling option for investors who cannot afford to take a risk with a portion of their capital or need a guaranteed income.

…and why not?

UK government bonds do not provide protection against inflation. A 10-year bond issued at 4% will pay 4% even if interest rates rise to 5%, and inflation is running at 10%. As such, while investors may not lose capital in cash terms, the purchasing power of their investment will be eroded over time.

There are government bonds that provide protection against inflation, called ‘index-linked bonds’. For these bonds, the coupon will vary according to inflation expectations. It’s worth noting that the capital values of bonds also have a sensitivity to moves in interest rates which can lead to capital gains or loss.

Comparison with Other Investment Options

UK Government bonds are considered a low-risk investment. If an investor buys a bond and holds it to maturity, they will receive their interest payment and get their money back at the end of the term unless the UK government goes bankrupt.

Corporate bonds operate in the same way as government bonds but are issued by companies. Investors buy into the bond, receive a coupon, and then get their money back at the end of the bond’s term. These can be ‘investment grade’, which are bonds issued by blue-chip, well-capitalised companies, or ‘high yield’, which are issued by companies in riskier industries, or with higher debt.

Corporate bonds are riskier than government bonds because companies are at greater risk of defaulting on their debt. For investment-grade bonds, the risk tends to be small, but it will be higher for high-yield bonds, particularly at vulnerable points in the economic cycle. Because they carry this higher risk, they tend to pay a higher coupon than government bonds to compensate investors.

This is different from investing in the stock market. When buying equities, investors are buying a share of a company, which entitles them to a share of any profits paid out in dividends. The hope is that the company will do well, raise its profitability, and the dividends and share price will rise. However, this is not assured. In theory, shares can go to zero if a company fails.

A major difference between government bonds and equities is inflation. An investor buying a government bond at 4% for five years will get 4% every year whether inflation is at 10% or 2%. At 2%, the investment looks like a good one, but at 10%, an investor will see their capital lose value in real terms over time.

Equities have historically offered greater protection against inflation. Companies have a range of tools to deal with inflation – they can put up prices, for example. In this way, dividends will often rise ahead of inflation. Equities also tend to have a higher long-term growth rate, which means that while there may be more short-term volatility, they tend to see greater capital appreciation over the long term.

How to invest in UK Government Bonds

There are a number of ways to invest in government bonds. The first is to buy a single government bond directly from HM Debt Management Office or from authorised agents, such as certain financial platforms. This has certain advantages in that investors know exactly the return they will receive over a certain period of time.

Another option is to buy bonds in the secondary market. This is where investors buy and sell bonds part way through their term. Prices in the secondary market can vary considerably over the term of the bond, depending on the market environment and the characteristics of the bond itself. For example, investors will be willing to pay more for a bond with a high coupon at a time when interest rates are lower than they would if interest rates were high.

Investors can also get access to government bonds through collective investments. There are UK government bond ETFs, which will aim to replicate a government bond index. This will give exposure to a diversified portfolio of government bonds with different maturity dates and coupons.

There are also actively managed government bond funds, where a fund manager will look across the government bond market, both the primary and secondary markets, for areas where bonds look to be the best value. They may take a view on the likely direction of interest rates and inflation and shape their portfolio accordingly.

UK government bonds will often form an important part of funds in the Sterling Strategic bond sector, though this will vary in line with market conditions. At times of economic weakness, for example, strategic bond funds may have more in lower-risk areas such as government bonds and then raise the risk profile of the fund during times of economic expansion.

For example, Ariel Bezalel, manager of Jupiter Strategic Bond, has been topping up on gilts. He believes UK inflation will undershoot the 2% target, paving the way for the Bank of England to cut rates. He says gilts are “very attractive at these yields”**. The Invesco Tactical Bond fund also has high weightings in UK government bonds***.

Recent performance and market conditions

In looking at the recent performance of UK government bonds, it is important to draw a distinction between what has happened in the primary market and what has happened in the secondary market.

In the primary market, the low interest rate environment that endured for a decade or more after the global financial crisis saw UK government bonds issued with lower and lower coupons. In 2021, for example, the UK government sold a 50-year bond with a coupon of just 0.125% ^.

For investors, this meant that they could achieve very limited income from a portfolio of UK government bonds. That completely changed when the Bank of England started to raise interest rates throughout 2022 and into 2023. New bonds were issued at much higher yields. In July 2023, for example, Britain sold a government bond at auction that will pay investors an annual return of 5.668% – the highest yield of any gilt sold since 2007 ^^. This means new investors in the government bond market can secure a higher income.

It has been a different picture in the secondary market. Yields move inversely with bond prices. As the yields on government bonds rose in response to higher interest rates, bond prices dropped. This means investors in collective funds saw some significant losses in 2022, with the average UK Gilt fund dropping 23.9%^^^. Recent performance has been more stable, and higher yields have helped compensate investors.

A significant point to consider is the capital gains tax implications. When bond prices rise, investors who sell their bonds before maturity may realise capital gains, which could be subject to tax. This is particularly relevant in a fluctuating interest rate environment where rising interest rates could cause bond prices to fall, impacting potential capital gains.

Wrap up

Government bond markets have been through an unusual period, and the UK bond market has been no exception. However, interest rates are now at a more normal level relative to history, and UK government bonds can play a ‘normal’ role in investment portfolios: generating a stable income, offering capital protection, and providing diversification from stock market investing.

*Source: M&G Bond Vigilantes, 2 February 2010

**Source: Jupiter, May 2024

***Source: fund factsheet, 31 May 2024

^Source: Reuters, 23 November 2021

^^Source: Reuters, 5 July 2023

^^^Source: FE fundinfo, calendar performance 2022