Fixed Income  

Low yields take edge off gilts

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.

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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 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.