Bond focus


John Royden, Head of Research

Most of us are fairly familiar with our government’s index linked bonds or gilts. Both the capital and the coupon grow in line with inflation. And they fall in value with deflation.

Capital gains on many bonds are tax free to UK individuals and this applies to the government’s index linked gilts; which is particularly interesting for UK tax payers.

But a number of corporates have issued index linked gilts as well. From a tax perspective the main difference is that corporate index linked gilts have their capital-gains-attributable-to-indexation taxed as income.

I suppose the rationale for this is that to the extent that a company has to pay a greater redemption amount on its index linked bonds, that amount is a tax deductible interest expense in the company’s accounts. If HMRC allowed individuals to escape tax on the gain then it would create a tax loop hole for extracting tax free profits out of a company.

An area of uncertainty is what happens if you suffer a capital loss. Presumably it is a deduction against your income tax liability.

In terms of what is out there, National Grid and Severn Trent have issued the National Grid plc 1.25% 06-OCT-2021 (“NG”) and the Severn Trent Plc 1.3% 11-JUL-2022 (“SVT”).

Tesco Personal Finance Plc trades under the name of Tesco Bank and as such is frequently called the Tesco Bank. It has issued the Tesco Personal Finance Plc 1.0% 16-DEC-2019 (“Tesco”). My mind struggles to find such a correlation between inflation and revenue as exists with National Grid and Severn Trent.

Working out the yield that you get on these corporate index linked bonds is tricky. First of all you have to reverse out the inflation implied by the prices of the various index linked gilts. Then you can use this inflation to predict what the cash flows are going to be from the corporate index linked bonds. Then you can work out what the gross redemption yields on a taxed and un-taxed basis.

All three bonds have attractive additional yields for non-tax payers when compared to index linked gilts. But that advantage diminishes significantly once you move up to the higher rates of personal tax. That is because individuals pay income tax on the capital gain to the extent that it is driven by indexation.

One of the restricting factors for individuals investing directly into corporate bonds is the minimum trade size. For many, so called “Institutional” bonds this is frequently £100,000 nominal. However in the case of these three bonds you can trade them in a “Retail” size of £100 nominal.

One difference between the Tesco bond and the others is that there is no explicit or parent guarantee from Tesco PLC. So, in theory, Tesco Bank could go bust and Tesco PLC would not be under any obligation to bail out the bond holders. And Tesco Bank could get sold as well. That is not true of the NG and SVT bonds which are issued by the quoted PLC and whose bonds have claims over all the assets of National Grid and Severn Trent. 

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