How can you benefit from higher interest rates?
The rise in UK interest rates means you can now generate higher returns from cash and lower-risk investments. If you are able to commit your capital for the medium term, UK bond markets may offer a particularly tax-efficient approach.
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The Bank of England’s Base Rate reached 4.25% last month, the highest level since the financial crisis of 2008. This is a dramatic shift for savers and investors who have lived with UK interest rates below 1% for more than a decade. There are now attractive opportunities out there if you know where to look.
The rise in interest rates is not entirely good news. Rates have risen so dramatically in response to an equally dramatic rise in UK inflation, which stood at close to 9% at the end of January. While today’s interest rates are attractive compared to what we have become used to, it is important to remember that returns from cash and most bonds are still considerably lower than inflation. In other words, they will not protect you from a loss of “real” (after-inflation) purchasing power. This may be the case for some time, given the Bank of England’s expectation that UK inflation will exceed 4% for much of the year.
Having said this, many of our clients hold some of their wealth in cash and lower-risk investments. We often advise clients to hold sufficient funds to cover their outgoings for one or two years as a “rainy day” fund. Clients may also need to keep assets in a liquid form when they face a known liability – such as a tax payment or loan repayment. Higher interest rates mean you can achieve more attractive returns on these liquid assets – and, importantly, on the right terms for you.
As always, the most suitable approach will depend on your specific circumstances. If you need access to your money at very short notice, cash deposits or money market funds may be appropriate. If you are a UK taxpayer and able to commit capital for a year or longer, you may be able to benefit from the very favourable tax treatment of selected UK government and corporate bonds.
UK bonds: the opportunity for UK taxpayers
Today’s higher interest rate environment has created a particularly compelling opportunity for UK taxpayers in UK government bonds (“gilts”) and certain corporate bonds (“qualifying corporate bonds”).
Following last year’s dramatic fall in bond markets, many bonds are now trading at a discount to their redemption (or par) value. As bonds approach maturity, their value should steadily rise towards par value. This increase is treated by HMRC as a gain – rather than income. Gains are, generally, taxed at a lower rate than income. There is an additional benefit for UK taxpayers who buy gilts and qualifying corporate bonds: there is no capital gains tax due on any realised gain.
This strategy allows you to generate very attractive net returns, while taking relatively little credit risk. For instance, a bank deposit offering an interest rate of 3.5% would provide an additional rate taxpayer with a net return of 1.925%. However, qualifying bonds with a maturity of a year to 18 months could offer a net return far closer to the initial 3.5%.
There are a large number of bonds that can deliver these attractive net returns. We can construct portfolios with staggered maturities to help meet a range of objectives. The strategy works particularly well when you have a known, medium-term liability – such as a mortgage repayment.
To take advantage of the opportunity, you will ideally be able to commit your capital until the maturity of the bond purchase. You can sell before then, however changes in interest rate expectations could mean that you receive less than anticipated. While we carefully assess the risk of any bond we invest in, it is also possible that companies or governments are unable to meet their obligations.
To explore which option may be most suitable for you, please do get in touch with your usual Cazenove Capital contact.
Attractive net returns
A greater share of the return comes from capital gains
The graphic above is a stylised illustration of a three-year bond with a 0.25% coupon and a pre-tax yield to maturity of 3.5%.
Investing in low coupon bonds: how it works
The return from a bond consists of two parts: the coupon and the change in value from the purchase price to par value. To give a simple example, imagine a one-year bond offering a 4% return. This bond could well come with a 2% coupon and trade at a 2% discount to its par value. The combination of the coupon and the discount deliver the total 4% return (4.08% to be precise). Many bonds are now priced to deliver a greater share of their return through this discount to par value. This effect is more dramatic for bonds with low coupons. These are the bonds that can deliver the most attractive net returns to UK taxpayers.
Overview of alternatives
| Summary | Benefits | Considerations | Indicative post-tax annualized yield as of 29 March 2023* | |
|---|---|---|---|---|
| UK bonds | Medium or longterm debt issued by UK government or companies | Attractive after tax return as a result of favourable tax treatment (for UK taxpayers) Works well to meet a known, medium-term liability (e.g. mortgage repayment) Can split capital across different maturities | You should be able to commit capital for at least six months (ideally more than a year) You can sell a bond before maturity but may not get the expected return Credit risk | c. 3 – 4% |
Other options
| GBP Cash deposits | Cash held at Schroder & Co or carefully-screened third parties | Can provide instant access Interest paid monthly | Interest is taxable as income Rates are not guaranteed and would fall (or rise) in line with changes to the Bank of England's Base Rate Counterparty risk on balances greater than the Financial Services Compensation Scheme limit (£85,000) | c. 1.75% – 2.25% – Cazenove Capital currently pays interest of the BoE Base Rate, minus 0.5% |
| GBP Money market funds | We invest in a small number of carefully screened funds, investing in short term government and corporate debt | Slightly higher returns than cash deposits Funds are highly liquid, allowing you to access capital quickly Diversified counterparty exposure | Interest is taxable as income Subject to third-party fund manager fees Returns are not guaranteed and subject to market and interest rate risk | c. 2.25 - 2.75% |
| UK T-bills | Very short-dated government debt We participate in the UK’s Debt Management Office weekly auctions Term of one, three or six months | Slightly higher returns than cash deposits Allow you to split capital across different maturities Can be rolled over at maturity into a new T-bill of same or different maturity | The return from T-bills is treated as income You can sell a bond before maturity but may not get the expected return Depending on level of demand across Cazenove Capital, may be subject to minimum ticket size | c. 2.25 – 2.75% |
*Yield range is indicative and is not guaranteed. Post-tax return range was calculated using 40 and 45% rate of income tax paid by higher and additional rate taxpayers.
Source: Cazenove Capital, as of 29 March 2023.
To explore which option may be most suitable for you, please do get in touch with your usual Cazenove Capital contact.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
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