GiltsMay 17 2017

Gilts are still a reliable option

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Gilts are still a reliable option

Recent warnings about rising correlations and talk of a potential crash in the bond market have caused investors to reconsider their positions in gilts. We think both fears are vastly overblown.  As long as you are not holding gilts solely for capital gains the case for allocating to the asset class remains strong.  

There has been much talk of the correlation between equities and gilts rising to the point where gilts cannot perform their traditional function as a diversifier from equities. However, if you look at the data closely this rise in correlations has not occurred. 

It is true that we have seen spikes in correlation over short periods of time – a few days or weeks – largely around changing expectations for the path of future interest rates or QE programmes (chiefly around Fed meetings). However, if you look over any more substantial time frame the correlation benefit from adding gilts to equities has remained substantial. 

Looking on a one-year rolling period since the financial crisis, for example, we can see that the correlation did turn positive during certain periods, but these were largely short-lived and the figure reached above 0.3 only momentarily, with the figure turning negative again on each occasion. A correlation below 0.3 on a one year basis is still very low.

In fact, it is notable that the period during this time that correlations were the highest (much of 2013 and 2014) was the period of a bull market for equities: a benign spike in correlations, in other words, during which both asset classes were generally making money. When the FTSE All Share corrected in the second half of 2015 the correlation fell and turned negative again, as gilts protected while equities fell.

This is a familiar pattern. Since the 1980s there have been periods of much higher correlations between the two asset classes. However, this has generally been when equity markets are rising.  When equities subsequently fell off a cliff – as with the Wall Street crash in 1987 and the dotcom crash in 2000 – correlations dramatically reduced and gilts made money as equities were selling off. 

This trend of high correlation was helped by the secular shift down in yields during this period, meaning that investors were making nominal returns in bonds over the longer run, as equity markets were also following a more traditional secular growth trend. 

A lot of the anxiety around yields comes from the fear that there is a bubble in bonds. Since the 1980s there has been a secular drift down in yields and the fear is that when this comes to an end, people will start selling bonds and keep selling as they would do with equities during a crash. Typically, quantitative easing is seen as having accelerated the final falls in yields and as being somehow 'artificial', and therefore likely to cause a sharp reversal when investors wake up to their mistake. 

However, there is no reason that yields should revert to the high levels we saw in the late 1970s and early 1980s. Bond yields are determined by growth and inflation expectations which are in turn determined by economic fundamentals such as demographics, technology and productivity: the return from bonds should compensate you for the nominal growth in the economy expected over the term of your investment plus a component for the risk of lending to a given issuer and for a given period. 

There are specific reasons that yields were so high in the late 1970s: an increase in spending for the Vietnam War in the US, plus demographic pressures and the birth of the Organization of the Petroleum Exporting Countries oil cartel more globally. These events resulted in inflation and a corresponding spike in bond yields.

Economic fundamentals now push in a different direction over the medium term: the world’s demographics are currently deflationary (China’s working age population peaked last year), while cheap shale gas and environmentally-friendly alternatives mean Opec’s power is significantly diminished. In developed markets such as the UK and the US the trend rate of growth has significantly slowed, which is at least in part connected to demographics.

The Federal Reserve’s own estimates of the future real interest rate in the US (reflecting their expectations for growth) is 1 per cent. Adding the 2 per cent inflation target onto this gives a rough estimate of 3 per cent as the target yield for the US 10-year Treasury (plus a term premium). It would take either dramatic increases in growth or inflation to see yields rise much higher than this, neither of which seem at all likely given the economic picture we have painted.

Our core expectation would be that investors lose money in gilts and US treasuries over the next 12 to 24 months as the economies continue to grow and the US looks to raise rates. In such a scenario equities should do well. Consequently, a diversified portfolio will be making money on its equity investments while paying away some of this as insurance on bonds.

However, our core expectation last year was for the same, and US yields moved very little over 2016 while UK yields ended lower, proving the value of simple diversification strategies. We see no reason this relationship should fundamentally change over the coming years; in fact, if yields are to enter a longer term up-trend then the correlation between equities and bonds should remain lower than it was in the 80s and 90s assuming the general direction of equities is up.

Thomas McMahon is a senior analyst of FE

Key points

In recent times there has been much talk of the correlation between equities and gilts.

A lot of the anxiety around yields comes from the fear that there is a bubble in bonds.

Investors may lose money in gilts and US treasuries over the next 12 to 24 months.