“Like picking up pennies in front of a steamroller.” This is the phrase a well-known multi-manager used to explain why he owned no UK government bonds, preferring to hold cash instead.
Government bonds exhibit sound protection against drawdowns
I remember nodding sagely to myself and writing the phrase down in my notepad, ready to unveil it to my colleagues when I returned to the office. The year was 2011, ten year gilts were yielding 3.5% and those pennies went on to deliver an annualised return of 8% over the next five years.
No asset has divided opinion in the investor community over the past five years like government bonds.
For many asset allocators, the government bond market has been an asset class in the midst of a giant bubble and one to avoid. For others, it has been one of the few asset classes to exhibit a negative correlation to equities, and thus a necessary constituent of multi-asset portfolios, no matter the price.
Today, with ten-year government bond yields in the UK at less than 1%, the steamroller could be ready to flatten investors.
So Why Own Government Bonds?
As a general rule, long-term government bonds are negatively correlated to large-cap stocks. There will be periods when the two asset classes move together, such as in the taper tantrum of 2013, but over the long term they will tend to move in opposite directions.
This is an extremely powerful tool for asset allocators. Combining asset classes with negative correlations can provide investors with superior risk-adjusted returns and help dampen the volatility of the overall portfolio.
Even with bond yields at their current low levels, the propensity for bonds to move in the opposite direction to equities continues to be demonstrated. Difficult quarters, such as Q3 2015 and Q1 2016, saw equity markets fall and government bond markets appreciate.
Government bonds also exhibit sound protection against drawdowns. Recent analysis by Morningstar Investment Management using data since 1975 showed that gilts offered impressive protection compared to other fixed income asset classes.
We also looked at the price return of gilts in these periods, as the carry benefit will clearly be lower today than historically, and without the income gilts offered capital protection rather than appreciating in times of stress. But this capital protection can still be beneficial to overall total returns.
As well as looking at history, there are other, more fundamental, considerations that an investor must wrestle with.
There is no doubt that macro tail-risks are increasing – a Chinese hard landing, a crisis in the Middle East, US elections and, closer to home, the recent Brexit vote – are all factors that are spooking investors. A recession and further rate cuts in the UK are now seen by many as likely.
Do Yields Have Further to Fall?
Since the global financial crisis, central banks around the world have been committed to stimulating growth and inflation through monetary easing and any weakness in economic data has seen government bonds shoot lower as investors quickly price in more action from accommodative central banks.
In the UK, it would also be remiss of investors to ignore what is happening in Europe and Japan, where nominal yields are in negative territory. Is the situation in the UK, with weakening economic data and rising uncertainty following Brexit, so different to Germany?
If the UK saw yields fall to German levels over 12 months, investors in a ten-year gilt would enjoy around a 15% return, while a fall in yields to Swiss levels would generate around a 20% return over one year.
The difficulty for asset allocators is balancing the reasons for continuing to hold government bonds discussed earlier with the fact that nominal sovereign yields are in uncharted territory. At the time of writing, the 10 year UK gilt yields less than 1%, the 10 year US Treasury less than 1.6% and the 10 year Germany Bund sits in negative territory. In addition, the curves have flattened significantly, offering little roll yield to investors.
As a standalone investment, locking in yields at these levels only really make sense in a world of deflation and negative economic growth.
It is these paltry yields that have prompted the portfolio management team at Morningstar to reduce our government bond allocation twice this year, continuing the trend we have been following for several years.
Today our government bond levels – like their yields – are at record lows, and we have predominantly been moving assets into cash. In 2010, for example, we advised conservative clients to invest 25% in gilts and 15% in cash. By early 2016, we had reduced the gilt weight to 14% and increased cash to 20% and then in July, we took the gilt weight down a notch further to 12% and cash up to 22%.
What are Gilts Really Worth?
For every asset class Morningstar Investment Management generates what we consider a fair value based on our long-term analysis. These values are calculated by discounting the asset’s cash flows at an adjusted rate commensurate to its risk and uncertainty. Current values are then compared to their fair value to identify expensive assets to avoid and cheap assets to own.
Our fair value for the UK 10 year gilt sits between 4% and 5% - clearly a long way above today’s rate of 80 basis points. As a result, UK government bonds are the second most expensive of the main fixed income markets we analyse, behind UK index-linked bonds. This means we expect the asset class to deliver a -2.6% annualised real return in sterling over ten years.
This brings us back to our original adage. Clearly, the unfortunate multi-manager was wrong to remove gilts from his portfolios. And our portfolios would have delivered superior returns had we kept 25% invested in gilts throughout the past six years. But hindsight is a wonderful thing and, given our fair value assumptions, gilts are now acting more like a hedge against future market turmoil than a source of return.
A version of this article appeared in International Investment magazine
