By Richard Pemberton, investment director at Quilter Cheviot
THE sharp rise in interest rates has presented an investment opportunity for income taxpayers to secure a decent return after tax, and with very low risk.
A rapid series of interest-rate increases from the Bank of England over the past 18 months has pushed bond yields considerably higher, ending a prolonged period since late 2008 when yields were close to zero. As interest rates were increased from 0.10% in December 2021 to 5.25% by August 2023, the yields on UK government bonds, known as gilts, rose by a similar amount.
There are two ways that an investor can benefit from an investment in bonds: via price appreciation and coupon (income) payments, and combined, which is referred to as the yield to maturity. This yield can broadly be compared to fixed deposit rates that are more commonly presented as an annual equivalent rate and, while both bond and cash rates have risen in tandem, there are distinct benefits for considering bond investment.
The primary benefit is the net return after tax
If you have a one-year fixed deposit with a bank at a 5.70% rate of interest, 100% of the return is delivered as income and taxed at the standard Jersey income tax rate of 20%.
Bonds, on the other hand, can be selected to deliver most of the return as capital gains. Some of these bonds have been issued in prior years when interest rates were near zero, so they have very low coupons to help minimise the income tax burden. This is especially appealing to those paying Jersey tax or trusts paying additional rate UK tax.
Tax-efficient short-term bond strategy
This is best illustrated with an example:
Source: Quilter Cheviot – Bank deposit and bond yield information is generic but believed to be fair and reflective of actual rates available, as at August 2023.
The one-year bank deposit matures in September 2024 when the interest of 5.70% is paid. The AER return is 100% generated by the interest paid at maturity. A saver with a 20% income tax rate would therefore receive a net return of 4.75%.
The AAA sovereign-backed bond carries a 0.25% coupon and matures in September 2024. The gross yield to maturity is 5.80%, potentially comparable to the one-year bank deposit rate at a headline level. The key difference is that the income component is only 0.25% gross, while the balance of the total return will be generated by the price appreciation at maturity, ie 5.55%. As only the 0.25% coupon is taxable, the net total return will be 5.75%, which is around 1.00% higher than the deposit.
Further benefits include the security and accessibility of the investment
AAA sovereign-backed bonds have never defaulted. You have always got your money back. And, unlike a fixed deposit, bonds can be sold ahead of maturity with the interest earned during the period included and the investment monies can be reassigned or withdrawn, as you prefer. While it is important to underline the risk that the price may be lower than when first invested, the likelihood that this figure is materially lower on a very low risk bond that matures within a year, is unlikely to be a significant consideration.
Interest rates are peaking – potentially great timing for longer-term strategies
There are currently great opportunities to construct bespoke bond solutions, perhaps targeting higher yields in the short and medium term instead of just having cash sitting in a current account. Future liabilities can be reduced and planned for ahead of time, such as for a house purchase, school and university fees, 2019 PYB tax liability and even just locking in the current levels of yields.
With interest rates highly likely to be at, or close to, their peak, this is an excellent time for investment in such a strategy. While some of the banks are currently paying decent rates on fixed deposits, they are not higher than the yields we have on AAA quality bonds, especially after tax, so it is wise to lock in bond yields while they are so attractive.
For more information, contact Richard on 01534 506070.
Investments and the income from them can go down as well as up, you may not get back what you invest.
This material is not tax, legal or accounting advice and should not be relied on for tax, legal or accounting purposes. Quilter Cheviot Limited does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting adviser(s) before engaging in any transaction
This is a marketing communication and is not independent investment research. Financial Instruments referred to are not subject to a prohibition on dealing ahead of the dissemination marketing communications. Any reference to any securities or instruments is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it.
Quilter Cheviot and Quilter Cheviot Investment Management are trading names of Quilter Cheviot International Limited. Quilter Cheviot International Limited is registered in Jersey with number 128676, registered office at 3rd Floor, Windward House, La Route de la Liberation, St Helier, JE1 1QJ, Jersey and is regulated by the Jersey Financial Services Commission and as an approved Financial Services Provider by the Financial Sector Conduct Authority in South Africa.