Fixed IncomeJul 9 2015

Low yields take edge off gilts

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Low yields take edge off gilts

In a 15th-century painting by the artist Hieronymus Bosch called The Conjurer, an audience is held rapt by a street performer’s cup and ball trick.

Meanwhile, one particularly mesmerised and hapless member of the audience is being relieved of his coin purse.

The story is an old one. Misdirection has been used for centuries to part folks from their hard-earned money. The most important message for investors is that the unfortunate victim in the picture, believing he knew the risks in the game, ultimately fell prey to something worse. Unfortunately, there is not always a tell-tale illusionist around to warn you of a pitfall. Careless investors can just as easily rob themselves of returns by focusing on the wrong things.

Investable assets fall into a wide spectrum of risk. Gilts – bonds issued by the Treasury – have traditionally been perceived as safe haven assets.

This assessment is based on the idea that the UK government is unlikely to miss a coupon payment or fail to return the capital it has borrowed. Gilts were also central to the Bank of England’s strategy to rescue the economy following the 2008 crisis. However, we fear the idea of gilts as safe havens is misleading investors in today’s environment.

In January 2009, when the financial crisis had starved most markets of their liquidity, the BoE entered into a two-pronged approach to restore life to the economy. The central bank continued to lower its official bank rate, and in March 2009 it was dropped to 0.5 per cent where it has remained. The BoE also began to buy high-quality assets in the market, financed by the issuance of Treasury bills.

The story has been much the same in the US and Europe, albeit with the timings of the policy decisions set apart

The new asset purchase facility was intended to free up capital and restore trust, to allow markets, businesses and the economy to begin moving again. The process is now more widely referred to as quantitative easing – or QE – and it ceased in the UK in 2013.

The combination of these two policy moves meant that cash as an investment option in the UK was effectively removed. Yields on gilts, with the BoE now acting as a deep-pocketed buyer, fell.

The story has been much the same in the US and Europe, albeit with the timings of the policy decisions set apart. In each case, the central bank has lowered base rates and stepped into support markets, and in each case, the valuations on government bonds have been driven to historic highs. With the economies of the US, the UK and the eurozone much recovered since 2009 the question now is when central banks will begin to raise rates again. Rising rates are bad news for bonds, and we do not believe that gilts offer sufficient return to compensate investors for this risk.

In early June, US Federal Reserve chair Janet Yellen commented that investors should expect a rate hike in 2015. Shortly afterwards, US Treasury bond yields rose steeply as investors reduced exposure. In Europe, macroeconomic data improved markedly through Q1 2015 and into April and May.

The ECB began its own QE programme in March, but the improvement in economic data has emerged too quickly to be attributable to the asset purchases. As such, the expectation is that economic growth and inflation numbers in the eurozone will only improve further with the continued market support from the ECB. This is a logical assumption.

In reality, the ECB will continue to support bond markets until at least September 2016, which will keep yields in Europe at relative lows. Inflation, too, is a long way from becoming a concern for holders of German bunds, but a reassessment of interest rate exposure – known as duration – seems prudent.

From its low in April to its early June peak, the 10-year bund yield climbed 90 basis points; rising from 0.08 per cent to 0.98 per cent. The rise in the 30-year bund yield was even steeper, the yield increasing by 123bps from 0.47 per cent to 1.70 per cent.

The story is much the same in the UK, albeit over a slightly longer time scale. From their lowest point at the end of January this year, both the 10-year and 30-year gilt yields have risen substantially. Both gilt yields have risen by 79bps to peak at 2.13 per cent and 2.83 per cent respectively. While the pace of gilt yield rises has been less dramatic, it has been no less important, equating to substantial declines in capital values.

In May, the BoE’s Inflation Report downgraded the UK’s economic growth forecasts. Following the relatively fragile gross domestic product growth of 0.3 per cent through Q1, the BoE has updated its expectation for full year 2015 growth in the economy from 2.9 per cent down to 2.6 per cent. Growth forecasts for 2016 and 2017 were also reduced, and inflation forecasts were adjusted down. This however, is another potential red herring.

The BoE’s Inflation Report was initially perceived as relatively ‘dovish’. Although gilt yield rises have been more muted than in Europe and the US, gilts have seen a steep sell-off that should not be ignored. Investors sticking resolutely to the idea of gilts as a traditional safe haven asset may already find their coin purse a little lighter.

The market currently expects the initial rate hike in the UK to occur in or around July 2016, while there is the potential, we believe, for the BoE to move earlier than this. It does not matter which view is proven to be correct. Some investors are focusing so hard on when rate rises might come that they have almost forgotten that they will.

It is important to highlight that we do not expect a sustained bear market for gilts to be triggered by the UK’s first rate rise. But gilt yields at these levels do not compensate investors for the degree of risk that they represent.

Michael Lake is investment director, multi sector fixed income at Schroders

Key points

Gilts have traditionally been perceived as safe haven assets.

The combination of low interest rates and QE meant that cash as an investment option in the UK was effectively removed.

The ECB will continue to support bond markets until at least September 2016, which will keep yields in Europe at relative lows.