Are there any Zero Coupon Gilts?
Yes and No.
Yes: Gilt-Edged Market Makers can "strip" gilts into indvidual cash flows to create tradable "Strips" which are in effect, a zero coupon gilt. These are used by institutional investors looking to hedge specific cashflows. However gains on Strips are treated as income, thereby negating the tax benefits to higher rate and additional rate taxpayer retail investors.
No: there are few if any gilts that are issued at primary auction by the DMO specifically as Zero Coupon Gilts. We thinks such as step would be innovative, but is only attractive to retail investors if the CGT exemption applies.
What is the return on Zero Coupon Gilts?
Zero Coupon Gilts could be issued at a discount to their nominal / face value, such that the return to the investor is the capital gain on from the discounted priced paid at purchase and the nominal value received on the maturity date, if held to maturity.
Why might investors want to invest in Zero Coupon Gilts
Aside from tax efficiency, there are three reasons why investors may wish to invest in Zero Coupon Gilts to align to a particular maturity.
Institutional investors:
What is the tax treatment of Gilt Strips and Zero Coupon Gilts?
What if HMRC deems there is no CGT exemption for primary issue Zero Coupon Gilts?
If a newly issued ZCG is treated by HMRC as a Gilts Strip for tax purposes (with gains taxed as income), then the DMO should consider issuing a Low Coupon Gilt "LCG" with say 1/8, 1/4 or 1/2 of a percent coupon for the retail market. This would be the next best alternative to a ZCG without having to rewrite the tax manual. These were issued during the low interest rate era and are proving highly popular now.
(It does seem inconsistent that HMRC treats private equity carried interest as capital gains (representing an IRR-type return on investment), but treats a Gilt Strip's carried interest (an IRR-type return on investment from the purchase price and maturity value) as income.)
Yes and No.
Yes: Gilt-Edged Market Makers can "strip" gilts into indvidual cash flows to create tradable "Strips" which are in effect, a zero coupon gilt. These are used by institutional investors looking to hedge specific cashflows. However gains on Strips are treated as income, thereby negating the tax benefits to higher rate and additional rate taxpayer retail investors.
No: there are few if any gilts that are issued at primary auction by the DMO specifically as Zero Coupon Gilts. We thinks such as step would be innovative, but is only attractive to retail investors if the CGT exemption applies.
What is the return on Zero Coupon Gilts?
Zero Coupon Gilts could be issued at a discount to their nominal / face value, such that the return to the investor is the capital gain on from the discounted priced paid at purchase and the nominal value received on the maturity date, if held to maturity.
Why might investors want to invest in Zero Coupon Gilts
Aside from tax efficiency, there are three reasons why investors may wish to invest in Zero Coupon Gilts to align to a particular maturity.
Institutional investors:
- To avoid reinvestment risk
- To structure a specific set of cashflows
- For currency hedging against strips in other markets
- To match future known liabilities (such as HMRC tax liabilities)
What is the tax treatment of Gilt Strips and Zero Coupon Gilts?
- Gilt Strips: The total return on Gilt Strips is treated as taxable income, negating the tax advantage (CGT exemption) of direct Gilts.
- Zero Coupon Gilt: It remains to be clarified whether any future dedicated primary issuances of Zero Coupon Gilts would have the similar tax treatment. We would argue that it should not as it is a dedicated issuance.
What if HMRC deems there is no CGT exemption for primary issue Zero Coupon Gilts?
If a newly issued ZCG is treated by HMRC as a Gilts Strip for tax purposes (with gains taxed as income), then the DMO should consider issuing a Low Coupon Gilt "LCG" with say 1/8, 1/4 or 1/2 of a percent coupon for the retail market. This would be the next best alternative to a ZCG without having to rewrite the tax manual. These were issued during the low interest rate era and are proving highly popular now.
(It does seem inconsistent that HMRC treats private equity carried interest as capital gains (representing an IRR-type return on investment), but treats a Gilt Strip's carried interest (an IRR-type return on investment from the purchase price and maturity value) as income.)