Gilts are becoming munis and no-one seems to have noticed

If you’re not based in America, chances are you don’t know much about the municipal bond market — even if you’ve spent decades managing fixed income portfolios. Sure, you’ve probably listened to the odd podcast and may have done touristic research on the Puerto Rican debt crisis. But you’ve probably neither traded nor held them.

Well, good news: that particular fixed-income-shaped void in your life can finally be filled (if you’re a British taxpayer). The delights of muni investing await… in the gilt market?

Let me explain.

The $4tn muni market is about the size of French and German government bond markets put together. So why is non-American exposure pretty non-existent? 

Simply put, they come with a massive tax break for American taxpayers. Without this, there are few reasons to hold them. How much is the tax break worth? As Invesco explain in their basic Muni primer, to work out the Tax Equivalent Yield (TEY) you have to do a tiny bit of maths:

Given that different Americans pay different marginal rates of tax federal income tax, the tax equivalent yields that Americans receive from the same bond will be different. The higher your marginal tax rate, the higher your TEY.

You could see this as a bung to the rich. Or maybe as a win-win: cheap finance for local governments; high TEYs for their rich funders. Regardless, the point is that even though Muni bond yields trade through US Treasuries, their TEYs make them look like a spread product that compensates holders for poor liquidity and higher credit risk.

This is nicely illustrated in the following chart and table, taken from Raymond James’s Municipal Bond Investor Weekly. They show that the yield on 10-year Single-A-rated Munis trades below USTs, but the Tax Equivalent Yield of 10-year Single-A-rated Munis traded UST+126bps, which is maybe roughly where a know-nothing foreigner might expect them to trade given the ICE BofA Single-A corporate index was marked on the same day at UST+128bps.

Despite a half-hearted effort, the UK doesn’t really have a municipal bond market. And taxpayers don’t even get a tax bung by owning the few UK local authority bonds that do exist.

But a quirk of legacy tax policy has meant that a chunk of the gilt market itself has become muni-like, insofar as it has begun to offer higher Tax Equivalent Yields to taxpayers than corporate credit. This is because gilts are capital gains tax (CGT) exempt in the UK.

Although not quite Frank Fabozzi, we can (maybe sort of) break down the yield to maturity of bonds into two components:

1. The running yield (income received each year for every £100 invested);

2. The pull-to-par (the difference between the purchase and redemption prices).

UK taxpayers pay income tax on the coupons they receive as part of the yield to maturity — the running yield bit. But they don’t pay CGT on the pull-to-par bit.

There are a bunch of gilts with teeny-tiny coupons issued during the COVID period of ultra-low bond yields. These COVID-era bonds have correspondingly tiny running yields (on which UK income tax is payable). For their yield to maturity to equate to that of comparable maturity bonds with higher (more current) coupons, their prices must sit far below par. As such, most of their yield to maturity comes from their pull-to-par, and this bit is tax-free.

Because of this, in bond-geek speak, the lowest coupon gilts are offering Additional, Higher and Basic Rate taxpayers Tax Equivalent Yields of anything up to Gilts+280bps, Gilts+230bps and Gilts+85bps respectively. Why buy (taxable) corporate credit when you’re offered these kind of TEYs? It’s slightly mad.

But it’s messy. Really messy. We can see this bond-by-bond in the chart below. The red dots show the yield to maturity of each conventional gilt outstanding. The STRIPS curve is plotted in tiny little specks. The blue dots show my approximate guess as to the Tax Equivalent Yield that other taxable investments would have to offer to top what gilts are offering an Additional Rate UK Taxpayer.

Conventional Gilt & STRIPS yield to maturity, Approximate Tax Equivalent Yield for Additional Rate Taxpayers

Pick the wrong five-year gilt? You’ll get a sub-2% annualised TEY. Pick the right one and you lock in close to 6% annualised TEY!

How much does HMRC stand to lose in tax from the exemption? The UK’s Debt Management Office doesn’t release data on the ownership profile of gilts on a security-by-security basis, but does say that households collectively own just under £3.5bn of the market. If we assume (wrongly) that all of these are super-low coupon gilts owned by additional rate taxpayers, this the CGT-exemption will cost a maximum of c£140m a year. My guess is that the actual number is maybe half this figure.

To entities who are already tax-exempt, or can’t benefit from the tax-advantage, the feature is worthless. Think pension funds, mutual funds, central banks, many international investors. These entities account for the vast majority of the market by stock and by flow. With UK households representing around 0.18% of the market, the tax benefits on offer to them have not really interfered with gilt pricing.

It looks to me like this could bring on the accidental birth of a British retail bid for gilts. Which is perhaps lucky, given that bond managers are now joining actuaries in looking to the moment when defined benefit pension schemes hit peak gilt and naturally move into decumulation, and when the Bank is offloading its QE portfolio.

Will the retail bid fill the void? Probably not. Will the tax system change to correct for this weirdness? I think it probably should, but I understand that doing so is complex and that the prize is small — for now.

Disclaimer: for the record, I own some UKT 0.25% Jan-2025. Hardly a meme stock. And wildly unlikely to go to the moon.