UK Bonds Explained: Gilts, Premium Bonds and Tax

Contents

• What is a bond?
• UK gilts explained
• Types of gilt
• Where to buy gilts
• What gilt yields tell you about the economy
• Premium Bonds
• How bonds are taxed in the UK
• When do bonds make sense in your portfolio?
• Frequently Asked Questions

Bonds are one of those investments that everyone has heard of but most people under 50 have never actually bought. Equities get the headlines, property gets the dinner party conversations, and bonds sit quietly in the background doing the boring work of preserving capital and paying predictable income.

That quiet reputation is misleading. The UK gilt market is where governments fund themselves, where pension funds park hundreds of billions, and where the price of money itself is set. If you hold a diversified portfolio, understanding bonds is not optional. And if you are a UK taxpayer, gilts have a specific tax advantage that most investors overlook entirely.

This guide covers how UK bonds work, the different types of gilt, where to buy them, how Premium Bonds fit in, and how all of it is taxed.

What is a bond?

A bond is a loan. You lend money to an organisation - a government, a company, a bank - and they promise to pay you a fixed rate of interest (the coupon) at regular intervals, then return your original capital (the par value or face value) on a set date (the maturity date).

If you buy a 10-year UK government bond with a 4% coupon and a £100 face value, you receive £4 per year in interest for ten years, then get your £100 back at the end. That is the entire deal.

The key difference between bonds and shares is predictability. A share gives you a claim on future profits that may or may not materialise. A bond gives you a contractual right to specific cash flows on specific dates. The trade-off is that your upside is capped - you will never earn more than the coupon plus any capital gain.

UK gilts explained

Gilts are bonds issued by the UK government, formally by HM Treasury and managed by the Debt Management Office (DMO). The name comes from the original certificates, which had gilded (gold) edges.

Gilts are considered one of the safest investments in the world. The UK government has never defaulted on its debt in modern history, and because it can raise taxes or - in extremis - print currency, the risk of non-payment is effectively zero. That does not mean gilts are risk-free in practice (more on that below), but credit risk is not the concern.

When the government needs to borrow money, the DMO holds gilt auctions where institutional investors bid for newly issued gilts. These gilts then trade on the secondary market, where anyone - including you - can buy and sell them.

How gilt pricing works

Gilts are quoted as a price per £100 of face value. A gilt trading at £95 costs you £95 to buy and will return £100 at maturity, plus the coupon payments along the way. A gilt trading at £105 costs you more than par, meaning you will take a small capital loss at maturity but collect above-market coupons in the meantime.

The price of a gilt moves inversely to interest rates. When interest rates rise, existing gilts with lower coupons become less attractive, so their price falls. When rates fall, existing gilts with higher coupons become more valuable, so their price rises. This inverse relationship is the single most important thing to understand about bond investing.

Types of gilt

Conventional gilts

The standard gilt. A fixed coupon paid twice a year, with the face value returned at maturity. Most gilts are conventional.

Examples on the DMO register include:

• Short-dated gilts (under 7 years to maturity) - lower sensitivity to interest rate changes, closer to a cash-like holding
• Medium-dated gilts (7 to 15 years) - a middle ground between income and stability
• Long-dated gilts (over 15 years) - higher yields but much more volatile when interest rates move

The longer the maturity, the more sensitive the gilt's price is to changes in interest rates. A 30-year gilt can swing 20-30% in price if yields move by a single percentage point. Short-dated gilts barely flinch.

Index-linked gilts

Index-linked gilts adjust both the coupon and the face value in line with the Retail Prices Index (RPI), giving you inflation protection built into the bond. If inflation runs at 5%, your coupon and principal both increase by 5%.

There is a catch. Index-linked gilts use RPI, not CPI. RPI typically runs 0.5-1% higher than CPI because of methodological differences (it includes mortgage interest payments and uses a different averaging formula). This works in your favour as an investor - you get a slightly more generous inflation adjustment than headline CPI would suggest.

Index-linked gilts tend to have very low nominal coupons (sometimes as low as 0.125%) because the real return comes from the inflation uplift. They are most useful when you believe inflation will be higher than the market currently expects.

Treasury bills

Treasury bills (T-bills) are very short-term government debt, typically maturing in 1, 3, or 6 months. They do not pay a coupon. Instead you buy them at a discount to face value and receive par at maturity. The difference is your return.

T-bills are used by institutions for cash management rather than by individual investors, but they are worth knowing about because T-bill yields set the floor for short-term interest rates.

Where to buy gilts

You have several options for buying gilts as a UK investor.

Through a broker

The most common route. Platforms like Interactive Investor, Hargreaves Lansdown, and AJ Bell all offer access to gilts trading on the London Stock Exchange. You buy and sell gilts just like shares, with prices updated throughout the day. Most platforms charge their standard dealing fee (typically £5-12 per trade).

You can hold gilts inside an ISA or SIPP to shelter the income from tax, though as we will cover later, gilts already have a useful tax advantage even outside a wrapper.

Via the DMO directly

The Debt Management Office runs a service called the DMO Purchase and Sale Service that allows individuals to buy gilts directly from the government. The minimum investment is just £100. There are no dealing commissions, though the service is slower than a broker - you post a form or submit online, and the trade is executed at the next auction price.

This route makes sense if you plan to hold gilts to maturity and do not need the flexibility of selling on the secondary market.

Gilt funds and ETFs

If you want broad exposure to gilts without picking individual bonds, you can buy a gilt fund or ETF. Popular options include:

• iShares Core UK Gilts UCITS ETF (IGLT) - tracks conventional gilts across all maturities
• Vanguard UK Government Bond Index Fund - a low-cost fund covering the gilt market
• Lyxor Core UK Government Bond ETF (GILS) - another low-cost option
• iShares Index-Linked Gilts UCITS ETF (INXG) - tracks index-linked gilts specifically

The trade-off with a fund is that it never matures. Individual gilts return your capital on a set date. A fund continuously buys and sells gilts, so your capital value fluctuates with interest rates indefinitely. This matters if you are using bonds to match a specific future liability.

What gilt yields tell you about the economy

Gilt yields are not just a number for bond investors. They are one of the most watched indicators in financial markets, used by everyone from mortgage lenders to the Chancellor of the Exchequer to gauge the economic mood.

The basics: what yield means

The yield on a gilt is the annual return you would earn by buying it at the current market price and holding it to maturity. When the price of a gilt falls, the yield rises (because you are paying less for the same stream of future payments). When the price rises, the yield falls.

This inverse relationship means that gilt yields move in the opposite direction to demand. If investors are rushing to buy gilts - typically during periods of uncertainty or fear - prices rise and yields fall. If investors are selling gilts - perhaps because they expect higher inflation or better returns elsewhere - prices fall and yields rise.

Yields as a confidence barometer

Rising gilt yields signal that the market is demanding more compensation to lend to the UK government. This can happen for several reasons:

• Inflation expectations - if investors believe inflation will be higher than the Bank of England's 2% target, they demand higher yields to offset the erosion of their purchasing power
• Fiscal concern - if a government announces large unfunded spending plans, gilt yields tend to spike as markets price in more borrowing and greater risk. The September 2022 mini-budget under Liz Truss is the textbook example - 30-year gilt yields surged by over 1.5 percentage points in days, triggering a pension fund liquidity crisis
• Central bank policy - when the Bank of England raises the base rate, short-term gilt yields tend to follow. Longer-term yields may or may not rise, depending on whether markets believe higher rates will slow the economy

Falling gilt yields signal the opposite: investors are accepting lower returns because they see gilts as a safe haven, or because they expect interest rates to fall.

The yield curve

The yield curve plots gilt yields across different maturities - from 1-month T-bills to 30-year bonds. Normally, longer-dated gilts yield more than shorter-dated ones, because investors demand extra compensation for locking their money away for longer. This produces an upward-sloping curve.

When the curve inverts - meaning short-term yields exceed long-term yields - it is one of the most reliable recession signals in economics. An inverted curve means the market expects the Bank of England to cut rates aggressively in the future, which it typically only does when the economy is weakening. The UK yield curve inverted in 2022 and remained inverted through much of 2023, correctly signalling the economic slowdown that followed.

Why this matters to you

Even if you never buy a single gilt, gilt yields affect your life. They directly influence:

• Mortgage rates - fixed-rate mortgages are priced off swap rates, which track gilt yields closely. When gilt yields spike, mortgage rates follow within weeks
• Annuity rates - the income you can buy with a pension pot is tied to gilt yields. Higher yields mean better annuity rates
• Government borrowing costs - higher gilt yields mean the government spends more on interest, leaving less for public services or tax cuts

Premium Bonds

Premium Bonds are issued by National Savings and Investments (NS&I), the government-backed savings provider. They are technically bonds, but they work nothing like gilts.

How they work

You buy bonds at £1 each (minimum purchase £25, maximum holding £50,000). Your capital is 100% secure and backed by the Treasury. You can cash them in at any time for their full face value.

Instead of paying interest, each £1 bond is entered into a monthly prize draw run by ERNIE (Electronic Random Number Indicator Equipment). Prizes range from £25 to £1,000,000, and the current annual prize fund rate is 3.80%.

That 3.80% is not your interest rate. It is the total prize fund divided by all eligible bonds. The odds of each £1 bond winning a prize in any given month are approximately 1 in 21,000. Most of the prize fund is paid out in £25 and £50 prizes, with only a handful of larger prizes each month.

The reality of returns

For the average holder, Premium Bonds will return somewhere close to the prize fund rate over the long run - but with significant variance. Someone holding £1,000 in Premium Bonds might win nothing for months and then get a £25 prize. Someone holding £50,000 has enough bonds to roughly approximate the average return, with occasional pleasant surprises.

The median return is lower than the mean, because a small number of large prizes pull the average up. For most people with modest holdings, a standard savings account paying a guaranteed rate will almost certainly beat Premium Bonds over any 12-month period.

When Premium Bonds make sense

Premium Bonds suit people who want absolute capital security, are higher-rate or additional-rate taxpayers (since prizes are tax-free), and find the lottery element motivating rather than frustrating. They are a poor choice if you need reliable, predictable income.

How bonds are taxed in the UK

This is where it gets interesting for UK investors, because gilts have a tax treatment that is genuinely unusual.

Gilt coupons: taxable income

The coupon payments from gilts are taxed as savings income. This means they fall under your Personal Savings Allowance (PSA):

• Basic-rate taxpayers: £1,000 of savings interest tax-free
• Higher-rate taxpayers: £500 of savings interest tax-free
• Additional-rate taxpayers: no PSA at all

If your gilt income exceeds your PSA, it is taxed at your marginal income tax rate (20%, 40%, or 45%). Gilts held within an ISA or SIPP are sheltered from income tax entirely.

Capital gains on gilts: completely exempt

Here is the unusual part. Gilts are exempt from Capital Gains Tax (CGT). If you buy a gilt at £85 and it matures at £100, that £15 gain is entirely tax-free. This exemption applies whether you hold the gilt to maturity or sell it on the secondary market at a profit.

This creates a powerful strategy for higher-rate taxpayers. By buying low-coupon gilts trading at a deep discount to par, you can convert what would be taxable income into a tax-free capital gain. A gilt with a 0.5% coupon trading at £80 generates very little taxable income but delivers a significant tax-free gain at maturity. The total return may be similar to a high-coupon gilt, but the after-tax return is substantially better for a 40% or 45% taxpayer.

This is one of the few genuine tax arbitrage opportunities available to UK investors, and it is completely legal.

Premium Bond prizes: tax-free

All Premium Bond prizes are completely free of income tax and CGT. This is one of their main selling points, particularly for additional-rate taxpayers who have no PSA and would otherwise pay 45% on savings interest.

Corporate bonds

Corporate bonds do not share the CGT exemption. Both the coupon and any capital gain are taxable (income tax on coupons, CGT on gains above your annual exemption). This makes gilts structurally more tax-efficient than corporate bonds for most UK investors.

When do bonds make sense in your portfolio?

Bonds play a different role depending on where you are in your financial life.

If you are accumulating wealth (20s-40s, decades from retirement), a heavy equity allocation is almost certainly the right call. Bonds dampen volatility but also dampen returns. Most young investors with a long time horizon and steady income do not need bonds at all.

If you are approaching retirement (5-10 years out), gilts become more useful. Short-dated gilts can act as a "maturity ladder" where specific gilts mature in the years you plan to draw income, giving you certainty that the money will be there regardless of what equity markets do.

If you are in drawdown, a gilt allocation provides stability and income. A common approach is to hold 2-3 years of living expenses in short-dated gilts or cash, with the rest in equities. This means you never have to sell shares during a downturn to fund living costs.

If you are a higher-rate taxpayer with cash to park, low-coupon discount gilts offer a tax-efficient alternative to savings accounts, especially if your PSA is already used up.

Frequently Asked Questions

Are gilts safe?

Gilts carry virtually zero credit risk because they are backed by the UK government. However, they carry interest rate risk - if you need to sell before maturity, you might receive less than you paid. If you hold to maturity, you get your face value back in full. The risk profile depends entirely on whether you plan to hold or trade.

What is the difference between gilts and corporate bonds?

Gilts are issued by the UK government. Corporate bonds are issued by companies. Corporate bonds generally pay higher coupons to compensate for the additional credit risk - the chance that the company might default. Gilts also have the CGT exemption, which corporate bonds do not.

Can I lose money on Premium Bonds?

You cannot lose your capital - NS&I guarantees to return your full investment on demand. However, you can lose purchasing power. If inflation runs at 5% and your prizes average 3.8%, you are losing 1.2% in real terms each year. Your money is safe in nominal terms but shrinking in real terms.

Should I buy individual gilts or a gilt fund?

If you have a specific date when you need the money, buy individual gilts that mature on or near that date. You will know exactly what you get back. If you want general bond exposure as part of a diversified portfolio and do not have a specific maturity target, a gilt fund is simpler and requires less management.

How do I find gilt yields and prices?

The Debt Management Office publishes daily gilt prices and yields at dmo.gov.uk. Your broker will also show live prices during market hours. The Bank of England publishes yield curve data that shows yields across all maturities, which is useful for understanding the broader interest rate environment.

Further Reading:

Smarter Investing - Tim Hale - The best UK-focused guide to building a portfolio that includes bonds, with clear explanations of how gilts and index-linked bonds fit into an evidence-based asset allocation. (Affiliate link - we may earn a small commission at no extra cost to you.)

The Intelligent Investor - Benjamin Graham - Graham's classic covers the role of bonds in a defensive portfolio and why the stock-to-bond ratio matters more than most investors think. (Affiliate link - we may earn a small commission at no extra cost to you.)