Gilt yields matter to anyone with a pension. They determine the price of annuities, the amount of income that can be taken in drawdown and for very cautious investors they determine the capital value of their portfolio.
But they are important to all other investors too. Most assets are sensitive to changes in gilt yields because their value, to a greater or lesser extent, is determined by the level of risk they represent compared to the ‘risk-free’ rate, which in the UK is the yield on a benchmark 10-year gilt.
When gilt yields rise, everything changes. In simple terms, corporate bonds are priced based on the amount of risk these bonds represent above the risk-free rate. Market analysts might consider, for instance, that the income you should receive from lending to BP for 10 years should be 2 per cent higher than what you would accept from the British government, and so the yield on a 10-year BP bond could be expected to be 2 per cent higher than that of a 10-year gilt. If gilt yields rise, the yield on BP bonds has to rise to maintain the ‘spread’ over gilts, and that means the price of BP bonds must fall because yield is inverse to price.
The king of markets
The price of equities is affected by gilt yields as well, although not in such a straightforward manner as for other bonds. If gilt yields are at 4 per cent, you would expect an equity to be performing considerably better through its dividends and capital gains to reward investors for taking a substantial degree of extra risk, say 8 per cent for a FTSE 250 company. But again, if yields rise you would need your equities to perform better to maintain that margin over the risk-free rate.
Other assets that are ‘bond-like’, such as real estate investment trusts (Reits) and high-yielding dividend equities, you would expect to be particularly sensitive to gilt yields – more so than for normal equities because their price is more to do with their dividend than expectations of future capital growth, and their dividend will be compared directly to the yield on a gilt. If gilts are paying a higher rate, Reits and other high-dividend equities will have to follow suit, and that can only happen by a fall in price.
So when gilt yields rise and the benchmark risk-free rate rises, most other asset prices automatically fall. The only dynamic that is likely to offset this is if the rise in gilt yields is due to an improving economic climate, which is deemed to be good for business and therefore good for equities, which may insulate equities from the rate rise.
Markets are heavily dependent on the risk-free rate. They operate sensibly when it is stable, but rapid changes can be chaotic. That is why gilt yields are king of the investment markets for UK pension investors.
Power behind the king
But if gilts are the king, then US Treasuries are without doubt the queen – the real power behind the throne. The yield on a 10-year US Treasury bond is the global risk-free rate that heavily influences the price of all other local benchmark government bond yields around the world, the relationship to gilts shown in Chart 1.