Billions of pounds of short-dated gilts are due to mature in the next 12 months but investors are struggling to match the high yields they have enjoyed for relatively little risk.

The first half of the year saw £80bn of short-dated gilts – bonds issued by the UK government – mature. According to UK government documents, a further £162bn of gilts are set to mature by the end of July next year, not including nearly £21bn of inflation-linked debt. 

The huge sums of money invested in gilts with a maturity of less than five years is testament to the jump in yields that accompanied the 2023 interest rate peak, where the base rate in the UK hit 5.25% and forced the coupon – or the amount of interest paid – on short-dated gilts higher, with some yielding as much as 5.3%.

The beginning of the year saw a spike in gilt purchases to highs not seen since 2008, with Hargreaves Lansdown reporting record bond buying in January, as two-year gilt yields hovered around 4.6% and five-year gilts at 4.65%. That was partly driven by yields, which move inversely to prices, on US government debt climbing in anticipation of the Trump administration.

For the whole of January, gilt trading was 75% higher than in January 2024 on the Hargreaves Lansdown platform, and nearly double the December 2024 trading rate.

However, as these gilts mature this year and next, investors may find themselves struggling to replicate the low-risk high-returns they had previously enjoyed.

‘Harder to replicate’

Mark Munro, co-manager of the Aberdeen Short Dated Enhanced Income fund, said the trade will be ‘harder to replicate’ due to the fall in yields, which are ‘anything from 1% to 1.5% lower than their peak in 2023 and below the magical 5% figure’.

On top of that, short-dated gilts are maturing at a rapid pace, meaning the potential to move into another short-dated bond is increasingly limited.

With the fate of gilt yields tied to interest rates, the fact that the cost of borrowing has reduced at a slower pace than the market had anticipated is buoying yields, however. 

Munro said yields are not reducing as quickly as had been expected 18 months ago – interest rates have only reduced 1% from their 2023 peak in the UK and US, as a wave of uncertainty swept into financial markets in the first half of this year.

This includes trade tariffs, war, and the uncertainty around Donald Trump’s fiscal plans. However, speaking late last month, Munro said he was predicting ‘one more rate cut in the UK than the market expects’.

The Bank of England left the base rate unchanged at 4.25% two weeks ago, but a third of the committee voted for a rate reduction and a cut is considered fairly likely at the next meeting in early August. 

Munro said Aberdeen’s ownership of the Interactive Investor platform allowed the asset manager to chart the huge flows of retail cash into gilts and money market funds back in 2023 as investors bought directly through their ISAs and Sipps, where both the income and capital gain are tax free.

However, those investors who had maxed out their allowances were still tempted into short-dated gilts thanks to a further tax advantage: capital gains on UK government bonds are tax-free, although income tax is paid on the interest. That created strong demand for so-called ‘low coupon’ gilts issued while interest rates were near zero, meaning most of the return comes from a tax-free capital gain upon maturity. 

Wealth management firms have also launched gilt portfolios for clients to capitalise on that theme. 

The ongoing strong demand meant two bonds issued last year just three months apart have vastly different coupons, despite both maturing in 2028. Investors who picked up the January issue enjoyed a 3.7% yield but those who invested in the March issue were awarded a 3.4% yield.

‘Nothing is different, it’s the same credit risk but there is a 30 basis points difference, which is very large for the same maturity,’ said Munro.

‘It shows the strength of demand from retail investors…that is not going away.’

Income options

With short-duration gilts few and far between and yields not looking as attractive as they once were, Munro argues his short-dated bond fund can bridge the gap.

He said investing in gilts provides liquidity and low volatility for investors and investing outside of the government bonds means ‘having to either sacrifice yield or dramatically increase risk’.

However, Munro added that the Aberdeen Short Dated Enhanced Income fund – which he runs with Thomas Drissner – was designed ‘as a means of solving this conundrum’.

It currently pays a yield of 5.8% and has been ‘designed to perform throughout the market cycle’ by investing in both global government and corporate bonds with maturities of up to five years.

Munro’s aim is to ‘lock into attractive yields and keep volatility as low as possible’.

‘Money market funds did that a year ago but now the yields on offer are going down and will continue to do so as interest rates come down, [investors] are finding the next step on the risk ladder,’ he said.

The opportunities for Munro currently lie in ‘higher quality investment grade BBB or A bonds’, which offer a yield that is 1% over government bonds.

While utilities used to be ‘less risky’, the sector has been plagued by increasing debt levels and ratings downgrades due to the investment required by environmental rules.

‘It is not the safest sector but it is a really interesting opportunity,’ said Munro.

‘The really interesting spot is autos, which has seen big issues of short term debt but has also been impacted by tariffs,’ he said.

Although it is not known how tariffs on the auto manufacturing sector will play out, and tariffs will impact it more than most, Munro said value ‘will come back to the market’.