From the election of Donald Trump to accelerating global growth, a combination of factors have conspired to derail the multi-decade bull market in bonds: Amid growing volatility, UK gilts prices have fallen steadily over the past six months. Investors have grown used to the low income available on gilts, but as yields rise and prices fall, might they reach a point when this safe haven looks like a safe haven once again?
On an absolute basis, it is difficult to argue that government bonds look good value at the moment, even after recent moves. The UK 10-year gilt currently has a yield of 1.18%. While this is substantially above its level of 0.52% in September last year, it is still below its level of 1.45% in March of last year.
Inflation Eats into Returns
Inflation is currently running at 2.3%, so investors are still losing capital in real terms by investing in gilts. The risk-reward also looks relatively poor. Barring a catastrophic scenario, it is difficult to see gilt yields moving much below their levels in 2016, but if inflation takes holds and interest rates move higher, they could sell off significantly.
What level would gilts need to reach before they became attractive again? If investors want a real return, over and above inflation, they would need around 2% as a long-term target. On top of this, they might also want some kind of inflation risk premium – perhaps 0.5%. As such, it is reasonable for investors to expect 2.5% over nominal GDP growth – currently at 1.7%. That gives a figure of more than 4%.
Why Investors Buy Gilts
In other words, gilts would have to move significantly to fulfil any normal measure of ‘good value’. However, people buy UK government bonds for reasons other than their absolute value. Pension funds are still compelled to buy bonds to plug any hole in their pension deficit, for example. Investors may use government bonds for diversification purposes. Equally, investors may simply buy bonds on the ‘greater fool’ theory – the idea that they can offload the bonds to someone willing to pay a higher price. Any of these factors may continue to support valuations.
But here too there are dangers. Pension funds are only compelled to buy gilts to shore up their funding deficits. If those funding deficits recede, then they no longer need to buy gilts in the same quantity. The level of interest rates is part of the formula for determining the level of those liabilities and if it were to rise, deficits would fall, reducing international demand. Markets tend to overshoot, and if sentiment turned against gilts significantly, valuations allow little room for manoeuvre.
David Roberts, head of fixed income at Kames Capital, says that as Brexit, or a second Scottish Referendum takes its toll on the UK economy and international sentiment, gilts may lose another key support. He adds: “We are nervous about markets that are heavily manipulated against the investor…if international support for gilts wanes, there would be some clear and present dangers surrounding gilts.” Weaker sterling is offering some protection in the short-term.
Diversification and Downside Protection
In contrast, Paul O’Connor, co-head of multi-asset at Henderson Global Investors, has recently been buying into gilts. His argument is largely around diversification. While he doesn’t expect strong returns from his holdings, he believes that gilts have regained the ability to act as a shock absorber in a multi-asset portfolio.
The UK gilt market has priced in a significant amount of inflation, which appears unlikely against the broader backdrop. He says: “After the sell-off, gilts are pricing 3% inflation over the next three years. I think that is an over-reaction.” In particular, he cites the potential impact of Brexit on the corporate and consumer sectors, which may act as a curb on inflation.
Gilts should remain a diversifier. That said, there have been occasions when gilt prices have fallen at the same time as stock markets. This has usually happened at times of high inflation and this remains the nightmare scenario for UK gilt markets.
At the moment, the market, the Bank of England and most forecasters are suggesting a benign inflation scenario, whereby inflation sees a temporary blip from the impact of currency weakness, which eventually moves out of the figures. However, it is possible to foresee a scenario where inflation takes hold and interest rates are forced to rise sharply. In this case, the effectiveness of gilts as a diversifier would reduce.
However, few have this as a central case. Ariel Bezalel, manager of the Jupiter Strategic Bond fund points out that there are plenty of deflationary factors still in place – ageing demographics, tech disruption, debt levels are high. The government has a vested interest in keep gilt yields low, to reduce the level of its debt repayments. As such, he believes low yields are here to stay.
In Conclusion?
There are no bargains in the gilt market even after the sell-off. Equally, they have some way to go before investors can use them as a reliable source of inflation-adjusted income. However, that is not the same as saying there are no reasons to buy gilts or that prices are likely to move catastrophically lower from here. Gilts remain a potential diversifier and deflationary forces are likely to keep yields in check.
