With an election on the horizon, a look at UK gilts can give an idea of how investors are feeling about the issuing government.
Government issued bonds, referred to as gilts in the UK, are often viewed as a safe investment, particularly in times of market volatility. Price and yield are inverse, so examining the performance of these assets can show how investors feel about the issuing government.
The outcome of the upcoming UK general election is proving difficult to predict. Despite the best efforts of the campaigning parties, nothing seems to be able to move the opinion polls to favour one party over another.
Both major parties could cause potentially volatile outcomes. If the Conservatives are voted back in, then the UK could be faced with a referendum on Britain’s continued membership in the EU. If Labour were to form a coalition with the SNP to form a majority, then the issue of a Scottish referendum could be brought up once again.
Gilt yields have remained fairly stable, implying that investors are feeling confident that, no matter the outcome of the election, the UK government will continue to repay its debts.
Promises, promises
While all the major parties have promised to cut the deficit, with some promising to break even or create a surplus before the end of the next Parliament, the International Monetary Fund (IMF) has warned that this would be near impossible, and that the UK would still be in debt by the time of the next election in 2020.
The deficit is one of the central issues in the election. As the ever-growing deficit is linked to the UK’s ability to repay its debts, investors may not be as confident about gilts as they once were. International investors have reduced gilt holdings by around £14bn since the beginning of 2014, according to Bank of England data, making this the lowest level of foreign gilt holdings since the financial crisis. This figure is not likely to increase until the dust around the election and a potential hung parliament settles.
However, bond yields remain low, especially considering the growing political volatility. This means that while investors may feel unsure about who could be the next prime minister, they feel more certain that, no matter who is in charge, the UK will still be able to pay back its debts on time.
Gilty pleasure
Investors do not necessarily have to hold UK gilts directly in order to benefit from their sense of security. Purchasing funds in the fixed-income UK gilts sector gives investors a chance to access a range of different types of UK gilts, with varying coupons and maturities, and add diversity to their portfolio. Table 1 shows the performance of the top 10 best perfuming funds in the UK gilts sector.
The best performing UK Gilts fund was the Newton Long Gilt, which is 93.1 per cent invested in UK Gilts, 5.1 per cent in UK fixed interest, and 1.9 per cent in money markets. The £91.8m fund was launched in March 1979 and is currently managed by Howard Cunningham.
The stated aim of the fund is to maximise returns from investments in British government-issued bonds that have a payment period of 10 years or more, and limit investment in other mutual funds to 10 per cent.
Schroders Institutional Long Dated Sterling Bond was the second best performing fund. Managed by Tom Sartain, the £76.6m fund, established in 2005, holds 95.8 per cent of its assets in bonds, of which 98.7 per cent are AA rated. Both the Schroders and Newton funds have consistently outperformed the sector average over the past 10 years.
Justin Oliver, deputy chief investment officer at Canaccord Genuity Wealth Management, said that he is more confident on gilts and sees little possibility of an adverse impact from the election. Yields will be driven by the interest rate backdrop, and even if interest rates do increase soon, it will likely be a small and gradual rise.
The figures are not likely to increase until after the election dust has settledDare to compare
While speculation has been rife over the election’s impact on UK gilts, it is worth noting how gilts are faring compared to other popular government-backed securities.
Seven of the G10 developed nations – Germany, Japan, France, Belgium, the Netherlands, Sweden and Switzerland – now offer negative yields on short-maturity bonds, meaning that it is costing investors to hold these bonds.
Global demand for safe assets is pushing prices up, and therefore yields down, so even negative yielding bonds are considered to be better than the alternative options. There is also the possibility of a currency gain by the time the bond reaches maturity, depending on the exchange rate of the bond’s currency.
In the rest of the G10 nations – the UK, US, Canada and Italy – yields are at record lows. At the time of writing, UK 10-year government bond spreads offered a 1.58 per cent yield, while the US stood at 1.89 per cent.
A low-yield environment continues to plague global markets. Though investors may not see high returns on UK gilts, they are still a safe place for savings, and offer better value than comparable alternatives.
Five questions to ask
1. Should I invest in the gilt directly or through a UK gilt fund?
There are a number of different types of UK gilts with varying maturity and yield. Rather than having to choose one, a UK gilt fund will combine a number of different types of yield, allowing for greater diversity in the investor’s portfolio.
2. How is the UK gilts sector defined?
According to the ABI definition, UK gilts are funds that invest at least 95 per cent of their assets in UK government gilts, UK government-backed securities, sterling-denominated (or hedged back to Sterling) AAA-rated, overseas government-backed securities. At least 80 per cent of the fund must be invested in UK Government gilts.
3. Why are gilts considered to be a safe investment?
Government bonds are considered to be secure because investors feel it is unlikely the issuing government will default on its debt payments. As they are a fixed income investment, the terms are set out when the bond is purchased and will not change, so investors like the certainty of a regular income, called the ‘coupon’.
4. What do interest rates have to do with gilts?
When interest rates fall, bond prices usually rise because investors want to get the higher rates while they can. When interest rates rise, their coupon becomes less attractive compared to other rates, so gilts will likely become cheaper. Even speculation around the movement of interest rates can urge investors to buy or sell, therefore impacting the price.
5. How are the price and yield of UK gilts determined?
Yield and price move in a mirror image of one another – when one goes up, the other goes down. Together, the two values make up the return profile of the bond. Yield is a way of expressing expected returns, and ideally includes an element of income and capital gain. A number of factors can impact the bond’s price and yield, including growth, inflation, interest rates, and political and economic climates.
