Gilts have lost their sparkle but still retain some appeal

Several factors need to be considered when investing in government bonds. The most important is that government bonds tend to perform well when their central bank is likely to deliver an ‘easing’ in monetary policy. 

Since the credit crunch, the Bank of England (BoE) has cut rates to historical lows and engaged in quantitative easing (QE) in order to pump money directly into the financial system. 

Mark Carney’s appointment as BoE Governor led to further shifts in bank policy, using ‘forward guidance’ to signal to the markets that interest rates were unlikely to rise until unemployment fell below 7 per cent, before moving on to signal that any interest rate increases in the future were likely to be limited. 

These policies led to a strong demand for gilts. The price of a gilt moves inversely to its yield, so as yields have fallen — reflecting the current low level of Bank Rate and the belief that interest rates are unlikely to rise much in the future strengthened — so the price on gilts has risen significantly. 

The decision to leave the European Union (EU) has further propelled gilt prices higher as expectations build for further interest rate cuts towards zero and even more QE. Valuations on gilts are now at historically rich (expensive) levels, with yields on gilts close to record lows. 

Yields on 10-year gilts are now about 0.8 per cent (mid-September 2016). This implies that an investor buying a 10-year gilt today will earn just 0.8 per cent per year until the gilt matures in 10 years’ time. 

The strong performance of gilts in recent years has therefore been driven by the increase in the price of gilts, resulting in declines in yields, rather than interest rates. When government bond returns are driven by reductions in yields, this effectively ‘borrows’ returns from the future, as strong price appreciation merely compensates investors for poorer future returns. 

For gilts to continue to perform as strongly going forward, yields will need to fall further. Currently the market is expecting the BoE to cut interest rates to about 0.1 per cent and stay there for a few years before rising to about 1 per cent. 

For yields to fall substantially further, the BoE would need to cut rates more, potentially into negative territory, or the market must continue to mark down the likely peak in interest rates in the future. This could materialise, as we have negative rates in several economies including in Europe and Japan, although the BoE sounds sceptical about the efficacy of negative interest rates. Should the UK economy perform worse than expected, perhaps in response to the decision to leave the EU, gilt yields could fall further given the expectations of more monetary easing.

While interest rates are unlikely to rise soon, the low levels of yields on government bonds offer little protection against future rate rises. Should interest rates even go above 1 per cent for example — perhaps in response to an improvement in the growth outlook or a belief that inflation is rising more quickly than expected — government bond investors might begin to see price declines, as the yields on government bonds rise to reflect rising interest rates. 

The main buyers of gilts have been the BoE, banks, overseas central banks, sovereign wealth funds, domestic insurers and pension funds. In many instances, buyers have not necessarily bought government bonds in the belief that they offer good value, but because they are used to implement monetary policy or for liability driven investments (LDI), whereby institutions hold assets such as gilts to provide the cash flows needed for future liabilities. As a result, government bonds can trade at rich levels, given the existence of these ‘price insensitive’ buyers.

The UK government issues gilts to fund the difference between what it spends and the revenues it receives from taxes. It continues to run a deficit, and as a result the size of the gilt market has increased since the credit crunch. 

The decision to leave the EU is likely to mean an increase in the deficit going forward, as the growth shock is likely to lead to lower tax receipts and potentially an increase in welfare spending. The deficit may further increase due to any attempts to boost growth further by, for example, spending on infrastructure. The increase in the supply of gilts may put downward pressure on prices, but this is likely to be offset by an increase in demand from the Bank of England. 

Gilts can provide a valuable diversification benefit, because they tend to perform well when risky assets such as equities perform poorly, as expectations build for an easing in monetary policy. Given current valuations, there is little cushion for gilts to perform as strongly in the future as they have in the past.

While the UK’s sovereign credit rating has dropped from AAA, to AA, the UK government is unlikely to default on its debt obligations. The Bank of England’s ability to create money to purchase government bonds makes it unlikely that the government would be forced to default. 

Such ‘money creation’ actions have been compared to those engaged in by Germany in the 1920s, and Zimbabwe more recently, which ultimately ended in very high levels of inflation. However, several countries have embarked upon quantitative easing and this has yet to lead to high levels of inflation. Nevertheless, investors who are concerned that inflation may pick up in the future may want to consider index-linked gilts.

Mitul Patel, head of interest rates at Henderson Global Investors

Key Points

Government bonds tend to perform well when their central bank is likely to deliver an ‘easing’ in monetary policy.

The strong performance of gilts in recent years has therefore been driven by the increase in the price of gilts rather than interest rates. 

The main buyers of gilts have been the BoE, banks, overseas central banks, sovereign wealth funds, domestic insurers and pension funds.