Fixed IncomeFeb 1 2013

Bubbling gilts – mitigate don’t pontificate

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Whether it was Bill Gross of Pimco famously warning back in January 2010 that gilts were on a “bed of nitroglycerine”, or just a growing sense of unease, certainly the astonishing interest rate position we find ourselves in quite rightly gives advisers and investment managers good reason for concern.

When Mr Gross made that somewhat inflammatory analogy those 10-year gilt yields were at around 4 per cent; subsequently they dropped to a low of 1.44 per cent (although now they have risen to 2.11 per cent) and as such he would have missed out on some significant gains.

Since the turn of the decade I am sure every sentient asset allocation group has been regularly asking the question – could yields really go any lower?

However, even at the most recent lows, you could still see Japanese yields at less than half of the equivalent UK bond. So potentially if you felt we were in a deflationary spiral, and we were showing signs of turning Japanese, then yes, they could go lower.

However, the popular fear is that a rise in yields will have a disastrous effect on the capital value and, as a result, bravura investment managers have begun to call an end to the bull market in bonds and other such similar headlines.

This, though, is an attention-grabbing measure rather than a pragmatic approach to managing portfolios to adjust for such risks.

There are actions that can be taken to mitigate the risks and ensure clients’ values are preserved and kept within their vital risk tolerances. For example, by reducing the duration of the gilts it is possible to significantly reduce the risk to losses and, of course, provide greater confidence as you see the pull to maturity.

Additionally, the focus on such bond risk has been primarily around the US and UK sovereign markets. Following Mr Draghi’s comments last summer about doing “whatever it takes”, the government debt of both Spain and Italy took on a very different hue.

Although their issues have not been resolved yet, progress has been made and if you are of the view that the euro is here to stay, then these may still provide a better diversifier for a portfolio.

One further action to dilute the risk would also include emerging market debt, which will benefit as the process of global healing continues.

Personally, I am delighted that people recognise this risk, but just as Mr Gross’s comments may have been too dogmatic in one direction, there is no excuse for us to do the same in the other. We all know we cannot time the market, but we can mitigate risk and dilute exposure to adjacent areas without losing our risk tolerance disciplines. The next few months will no doubt see other issues arising over rating concerns which will be an excuse for further nerves, so action now will calm potential problems later.