Canny investors are using a nifty trick to guarantee a steady tax-free income.

There is a clever and relatively simple way of buying UK Government bonds that can secure some of the best rates around – even when interest rates plummet.

Known as gilts, they pay out a regular income, called a coupon. And at a set date you get all your money back – except in the extremely unlikely event the UK Government defaults on its debt.

UK gilts can be bought through all investing platforms, which have made it easy to stash them in your Isa. And financial advisers increasingly tend to recommend them to higher earners who have already maxed out their Isas for the tax perks they offer (more on this later).

As with most investments, they are subject to a dealing charge and an annual fee, but investors are increasingly using them to build what's known in the finance industry as a 'gilt ladder'.

This involves buying a whole basket of gilts with different end dates. By maturing serially over time it can reduce your interest rate risk and guarantee regular payments. This arrangement can be particularly useful for those in retirement who want to generate structured, reliable returns.

The strategy is of particular interest right now because in recent months gilt yields have soared to highs not seen since the late 1990s.

The yield on ten-year UK gilts – a key measure of Government borrowing costs – was off recent highs but remained at 4.9 per cent on Friday on the back of ongoing turmoil in the Labour Party, above-target inflation and a raft of global uncertainties. Here's everything you need to know about investing in gilts – and how to build your very own tax-free gilt ladder.

How gilts work

Governments issue bonds to borrow money, offering them with a range of different maturities, such as three months, a year, ten years, 30 years and so on. This is the length of time governments are giving themselves to pay investors back.

Short-dated bonds mature quickly and tend to be deemed less risky than long-dated bonds. This means the safer, short-dated bonds tend to pay investors less than longer-dated ones, but they can still beat savings rates from high street banks.

Build an income stream

A gilt ladder can be used to spread investments across many years, says Alan Barral, financial planner at wealth manager Quilter Cheviot.

He explains: 'This means capital is returned in stages, providing predictable cashflows over time.

'We have seen a significant number of clients take advantage of this opportunity, using gilts as a highly tax-efficient way of holding large cash balances outside a cash Isa.'

Investment platform AJ Bell has compiled this gilt ladder, made up of gilts that are currently trading below par – meaning you can buy them for less than they are worth at maturity, which is typically £100.

The ladder is made up of three bonds, all of which pay coupons twice a year. The shortest dated bond matures in October this year and pays a coupon of 0.375 per cent. This means you would get paid 18.75p as income if you bought now and held to maturity. The bond costs £98.50 but at maturity in October, you would get £100 back (the price it was originally issued at). That is a £1.6875 gain overall, equating to a 1.71 per cent return on investment.

The second bond matures at the end of October 2028 and pays a coupon of 1.625 per cent. This means you would get paid an income of £4.06 (five instalments of 81.25p). It is priced at £93.71 today and would pay out £100 upon maturity. The £6.29 capital gain and £4.06 income equal a total gain of £10.35, which is an 11.04 per cent return.

The third bond matures in January 2029 and pays a coupon of 0.5 per cent. This means you would receive £1.50 as interest. It is priced at £90.10 and would pay out £100 at maturity. Add the £1.50 income with £9.90 capital gain (£11.40) and you've made 12.65 per cent return.

To keep things simple, the yield formulas in these examples use the 'clean price' that does not include accrued interest between coupon payments. By buying these together, you guarantee that your income will be spread over the next three years.

The tax perks

The coupon is subject to tax, in the same way that interest is paid on cash savings. But for anyone looking to invest outside Isas (which have an annual £20,000 limit) and pensions – especially those paying higher or additional tax rates – gilts can be very tax efficient, as the price gains on them at maturity are exempt from capital gains tax.

This means you can make impressive gains on gilts with low coupons that you bought for a discount.

Dan Coatsworth, head of markets at AJ Bell, says: 'For a lot of people, the big appeal is the gain on a gilt at maturity is tax-free. The income from the coupon is taxable but you can buy gilts maturing over the next few years paying only a small coupon, meaning the majority of the gain comes tax-free at redemption.

'This is a huge draw when you compare gilts to a cash savings account, where the returns are taxable if you're holding the money outside a pension or Isa.'

Coatsworth says for higher and additional rate taxpayers, the money you get back from buying short-dated gilts can far exceed what you might get from a cash account.

If doing these sums yourself sounds overwhelming, it might be worth paying a financial adviser to build a gilt ladder for you.