Do UK gilt ETFs make sense for fund selectors?

Tax efficiencies of the underlying are not passed through ETFs

Jamie Gordon

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UK gilt ETFs provide investors with the usual diversification benefits of opting for a fund-based fixed income exposure, however, this may not be the most prudent choice for fund selectors looking to maximise tax efficiency for end clients.

This is because UK gilts bought directly are exempt from capital gains tax (CGT), meaning any profits realised from selling or redeeming the bonds are tax-free, whereas high earners are typically subject to 20% CGT.

On the other hand, ETFs, open-ended investment companies (OEICs) and unit trusts are subject to CGT.

Furthermore, individual gilts are “really useful” as tools for liability matching for higher and additional rate taxpayers, according to David Henry, financial planner at Sylva Financial Planning.

“For clients who have a tax liability to pay in January of next year, there is a gilt issue maturing on the 31 January 2025 which pays a 0.25% coupon currently trading at a discount.

“As the ‘pull to redemption’ on gilts is tax free, this kind of approach can be very tax efficient to meet defined liabilities,” Henry said.

Speaking to ETF Stream ahead of the Bank of England’s rate pause at the end of 2023, former 7IM senior investment manager Peter Sleep said while he was not persuaded by the tactical case for UK gilts, he noted it was “not a bad idea to buy gilts directly” for additional rate taxpayers.

“Gilt ETFs are just not attractive for higher rate taxpayers as they do not enjoy this tax break,” he added.

However, portfolio construction purposes, such as the need for diversification, mean broad-basket approaches still serve a purpose when capturing UK sovereigns.

“When bonds are being used within a portfolio for diversification purposes however, I would suggest that clients access the asset class through collectives rather than buying individual bonds,” Henry said.

“This is to ensure there is a broad enough spread of exposure to the asset class, getting enough exposure to fixed interest by buying individual gilts is likely to be too unwieldy for most investors.”

Henry suggested a key reason for investors to opt for a diversified approach is to match the likely global footprint of their equity portfolios.

“As 2022 showed us, gilts can materially underperform other countries' debt,” he concluded.

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