Investors should not write off government bonds

Bond fund managers acknowledge that it is hard to achieve attractive returns when 10-year US treasury notes are yielding 1.8 per cent, 10-year German bunds 1.5 per cent and 10-year gilts 2 per cent.

Even from a multi-manager stance, the only government bond funds held by the Thames River Multi-Manager range are those able to short the gilts market.

Stewart Cowley, head of fixed income at Old Mutual Global Investors, feels that when long-dated bond yields go up it will be by at least 2 per cent and stresses that it is not a question of “if” this happens but “when” and “how quickly.” He points out that a 1 per cent rise in 30-year bond yields can result in a fall in capital value of more than 20 per cent, meaning that investors could experience equity-style losses from so-called “safe haven” holdings.

But other experts are quick to highlight that downside risk is reduced by the fact that bond funds commonly hold a spread of short and long-dated issues. Ben Bennett, head of credit strategy at Legal & General Investment Management, points out that if you bought every single constituent of the major sterling gilt indices in the right proportion then a 1 per cent rise in yield would result in roughly a 9 per cent fall in capital.

Philip Laing, head of rates at Standard Life Investments, agrees: “I think you will find that the vast majority of bond managers are suspicious of the valuation of their asset class and are certainly concerned about the prospect of a rise in yields at some point.”

There are also other cushions to consider. UK pension funds and insurance companies have to own significant quantities of bonds for regulatory reasons and the US Federal Reserve is still buying treasury bonds and could ramp up its purchasing if yields rise.

“It is absolutely key to realise that yields are being manipulated by central banks and that the actions of private investors can only have a limited impact,” says John McNeill, investment manager at Kames Capital.

“For example, the Bank of England owns approximately 30 per cent of the outstanding stock of gilts and a further 30 per cent are owned by overseas central banks.”

Furthermore, there is a limit to which even most private investors will bail out of this asset class. For example, Towry, the wealth manager, currently has its lowest ever exposure to government bonds, but it is not intending to reduce this any further “unless something extraordinary happens”.

Indeed, investors could even start seeing government bonds as representing value again if yields do rise. Ian Kernohan, economist at Royal London Asset Management, is expecting 10-year gilts to rise from 2 per cent to 2.9 per cent this year, and feels that they could start to look attractive at this level.

While many experts do not rule out rises of 0.5 per cent to 1 per cent this year as the “safe haven premium” unwinds somewhat, the consensus view is that steeper rises won’t occur unless interest rates rise – which is most unlikely to happen while economic growth remains so sluggish.

Vicky Redwood, chief UK economist at Capital Economics, says: “We don’t see gilt yields rising very sharply for a couple of years as interest rates are likely to remain low and US and UK demand for safe havens is likely to remain strong.

“We feel that the eurozone crisis is likely to flair up again and expect more quantitative easing in the UK and US, which will keep demand for bonds strong.”

So, while it is hard to get excited about government bonds, no-one should write them off until they can be sure that cash returns are going to rise.

Edmund Tirbutt is a freelance journalist

EXPERT VIEW

Johan Jooste, chief market strategist at Merrill Lynch Wealth Management EMEA:

Rising uncertainty and some signs of overheating in global equity markets may lead to a short-term market correction – given strong fundamentals relative to bonds, there is opportunity to use market weakness to buy equities “on the dips”. This view is consistent with the continuing, slow rotation away from fixed income markets and into equities evidenced by recent fund flows