UK’s Low-Coupon Bond Rush Is Overdone, Says NatWest Markets

Demand for a niche sector of the UK bond market that offers rich Britons a tax break is at risk of faltering, according to NatWest Markets.

For months, wealthy UK investors have been scooping up low-coupon gilts, putting them in line for hefty tax-free payouts. That demand may have run its course as the bonds have outstripped peers, said Imogen Bachra, head of economics and markets strategy at the bank, in a note to clients.

The securities have been popular because holders only pay tax on the interest income accrued — and not on any capital gains. That means investors are paying more to own these bonds than comparable notes with higher coupons.

Read more: UK Bond Trading Is Surging as Wealthy Brits Grab Tax-Free Gilts

Market makers now want to get in on the action, calling for more such debt to be issued, according to the minutesgbp of the latest meeting of the UK’s debt management agency with banks and investors. They may have missed the boat.

“Retail buying is perhaps not as large as the current market narrative would suggest,” Bachra said. “We think there is a limit to how much richer these low coupon bonds can go versus high coupon.”

The recent move by the Bank of England to start cutting interest rates is now driving down yields across the UK bond market. While the BOE has been a major supplier of low-coupon bonds via a quantitative-tightening program designed to reduce its balance sheet, NatWest Market forecasts active sales will cease when policymakers provide an update next month.

That could potentially remove the supply of low-coupon bonds to the market, so investors may have limited appetite to take a stance before the BOE meeting on Sept. 19, Bachra said.

“The high coupon versus low coupon curve debate in gilts has dominated many of our client conversations of late,” Bachra said. “Ahead of a decision on QT, however, there may be little appetite to fade this richening significantly.”