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A UK government bond fund that uses option-writing can provide a highly effective way of protecting capital without necessarily foregoing an inflation-beating rate of return from the gilt market during a UK recession.

From an economic standpoint, reading the headlines recently has become a gruelling affair. It seems that every day the news is worse. Inflation, oil prices, the housing market, job losses; people are now finally accepting that the UK is in recession.

In times like these, it is not at all surprising to find a certain degree of casting about among investors as they try to protect their capital and find some degree of return on their money. For some, the quest to “call the bottom” will continue, focusing doggedly on the good times that must, they assure us, be right around the corner. For others though, with lower tolerance for the vagaries of the equities and commodities markets, the call is out for a flight to quality.

During volatile times prudent investors reassess their exposure to low-risk assets to ensure that their portfolios preserve enough capital to take advantage of buying opportunities in the future. UK government bonds – “gilts” – have always been a staple of this class.

Gilts have a number of highly desirable characteristics. Crucially, they are liquid – just try selling a corporate bond in today’s markets to see what illiquid means – and as sovereign UK government paper their counter-party risk is practically non-existent.

Given the twin benefits of liquidity and security, the question becomes how to derive the best returns from a fund which focuses on the class.

The first strand of an effective investment process for achieving strong returns from gilts is to actively manage a portfolio of gilts rather than just one gilt investment. This is fundamentally dependent on where the best value can be found in the gilt market in terms of short, medium or long duration. Investors who hold fewer than six or seven gilt positions risk volatility or short-term losses by being misplaced along the yield curve.

Once the base portfolio is constructed, it is then vital to constantly monitor the gilt market to establish where value lies. Then, having established a view of where the best opportunities to add value lie within the market, the fund’s modified duration can be adjusted to take advantage of the market’s movement or lack thereof.

Of course, even with careful and deliberate monitoring of the gilt market, one is still vulnerable to variation in the market itself. To combat this, some funds use a highly refined option-writing strategy. It reduces volatility and can significantly enhance the returns that can be achieved from gilts by the fund.

Here is an example of how a covered call-option works in the context of the gilt market:

The purchaser of a call-option has the right – but not the obligation – to buy a gilt at a fixed price on an agreed future date. If one investor owns a gilt valued at £98, the option-buyer might pay 50p to buy the right to purchase that gilt from the first investor in three weeks’ time at a price of £98. If the gilt price rises to £100, then it would make sense to complete the purchase and buy the gilt for £98. This is known as “exercising” the option.

If the price of the gilt falls to £96 there would be no point in buying the gilt from the initial investor at a price higher than the one available in the prevailing market. In either case, the seller, or “writer” of the option, pockets the 50p premium and is obligated to deliver the gilt only if the option buyer has exercised his right to purchase.

The option writer is said to be “covered” if he or she actually owns the gilt against which the option is written.

By the timely writing of call options, a gilt fund can generate an extremely valuable additional stream of income through the periodic receipt of premium income, providing a performance kicker without adding downside risk to the overall portfolio. The main risk that the option writer faces is that his gilt is “called away”. This only happens in a sharply rising market and therefore the prime risk to funds that execute this strategy is one of relative underperformance in a sharply rising market.

The writing of call options on gilts is a very deliberate and tactical process, not a formulaic, quantitative or automatic one. The pay-off to the strategy is the stability of return and tends to work particularly well when there is an obvious bull or bear theme in the market. While many discretionary managers have traditionally held gilts directly, outsourcing this part of their portfolios to a dedicated manager can be extremely valuable as most investors lack the systems, agreements, time and expertise to effectively profit from writing covered calls on gilts. All else being equal, and with favourable conditions, it is possible for a gilt fund to earn as much as 150 to 200 basis points in excess of the index returns through this strategy, if successfully implemented over the course of a year.

The final appeal of the gilt market comes from the taxman. Many advisers buy gilts directly because gains made are not subject to capital gains tax, whereas gains an investor makes when selling a fund are liable to the tax. From April of this year CGT fell from 40 per cent to 18 per cent and while this may appear to make gilt fund investors worse off, in fact, as with most things to do with tax, life is not quite so simple.

While a direct holding in gilts is not subject to CGT, the flipside is that losses made on gilts cannot be offset against gains made elsewhere in a portfolio (for example, losses on shares) for CGT purposes. By contrast, gains made by an investor in a fund are subject to CGT but losses can be offset. It therefore may make sense for any client who is sitting on big gains from direct gilt holdings to consider crystallising them and placing the profits in a fund.

Investors can also shelter themselves from tax by using their Isa and pension allowances – especially within a Sipp or Ssas. Tax considerations, appetite for risk, security of capital and outperformance of gilts in some environments when compared with other asset classes are important for making the decision to invest in a gilt fund.

An element of gilt exposure is essential for most clients’ portfolios, particularly at a time such as now when many clients are more sensitive to the volatility that equities – and now commodities – have delivered. With an increasing number of well-known pundits calling recession rather than inflation as the larger risk to the UK, investors may be well served by reviewing their portfolios to ensure that they are maximising the returns available from this stable, core, asset class.

Ian Williams is the lead manager of the City Financial Strategic gilt fund

Main points:

- UK government bonds are growing in popularity as risk-averse investors seek a low-risk asset to preserve their capital in while waiting for more favourable economic conditions.

- As well as being secure, gilts are also liquid. The same cannot be said of UK corporate bonds, which can prove hard to sell in an environment like this.

- By including a call option, a gilt fund can generate an extra stream of income for investors, without adding any risk to the overall portfolio.

- Call options are easy to set up, with the only potential downside being that they may lead a fund to marginally underperform in sharply rising markets.

- There are tax implications for using gilts, particularly in terms of capital gains tax.