Gilts have lost their sparkle but still retain some appeal

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The pros and cons of bonds

Gilts have lost their sparkle but still retain some appeal

While UK government bonds, or gilts as they are known, have long held the reputation of being a ‘boring’ and ‘safe’ asset class, the robust returns since the credit crunch – the Global Financial Crisis that began in 2008 – have proven it to be anything but. Can the strong performance of this safe haven asset class continue over the coming years?

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. 

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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.