Bond Watch: is one of the most popular gilts overpriced?

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.               

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.               

• Invest with ii: How Bonds & Gilts work | Tax Rules for Bonds & Gilts | Open a SIPP

Tax hack means lower yields 

One of the most popular bonds on the interactive investor platform is TG61, a gilt maturing in 2061 that pays a 50p coupon. The long life of the bond and low coupon means that its duration, or sensitivity to interest rates, is very high.  

Because capital gains are not taxable on gilts, investors are using this bond to bet on interest rates falling faster than the market anticipates. A drop in rates would lead to a big bounce in the price of TG61. 

But its high duration has made it very popular. This means that it yields less – and is therefore more “expensive” – compared with a bond maturing just a year earlier with a higher £4 coupon: TR60. The yields are 4.4% and 4.7% respectively. The durations are 29 and 17.5 years, according to TradeWeb.

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Does this mean that investors are getting a bad deal for TG61? Not at all. As coupons are taxed as income, and capital gains are tax free, bonds where more of the return comes from price movements and the return of the (tax-free) par value at maturity are understandably more expensive.  

Robert Burrows, a fixed income fund manager at M&G, explains: “Some would look at this and come to the simple conclusion that they would rather own the 2060 maturity and get an extra 0.3% per year until maturity, which over the long term is, in fact, not insignificant. However, when we circle back to the tax efficiency argument, the 61s are still better value. We need to adjust the bond yields to consider the tax element.” 

He adds that there is now a two-tier gilt market – gilts with low coupons and gilts with high coupons, with high coupon bonds yielding the most, but being less tax efficient for investors who have filled up their ISAs already.  

US interest rates unchanged 

The US central bank left interest rates unchanged this week, flagging a “lack of further progress” on inflation. 

Rates have been between 5.25% and 5.5% since last July, and while investors went into 2024 expecting rate cuts by the spring, it is becoming more and more unlikely that there will be any rate cuts this year.  

Tiffany Wilding, managing director at fund group PICMO, says that there could be one cut this year, but the probability of no cuts was growing. 

Wilding says: “We think the median 2024 rate forecast will still reflect the Federal Reserve expectation of at least one cut in 2024. However, the probability has risen significantly that they don’t cut at all.  

“Of course, in the event that the economy weakens and the unemployment rate increases, we would expect the Federal Reserve to cut in that scenario, and cut aggressively if needed.” 

Inflation in the US rose to 3.5% for the year to March, from 3.2% in February.  

• UK interest rate outlook: will Bank of England cut first?
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• Benstead on Bonds: why gilt auction access is a win for small investors

The news out of the US matters because the Federal Reserve is very influential and impacts what other centrals banks do. If it cuts, then that makes it more likely that the Bank of England will cut rates too.  

Nevertheless, it looks like the European Central Bank (ECB) will be one of the first to cut rates. Inflation in the eurozone is still falling, and was just 2.4% in April, strengthening the case for a rate cut from the ECB.