Fixed Income  

UK government bonds set to diminish in popularity

This article is part of
Guide to investing in 2020

UK government bonds set to diminish in popularity

UK government bonds are set to diminish in popularity over coming months after a Conservative election victory reinstated investors’ faith in riskier assets. 

Gilts retreated with the 10-year yield reaching 0.82 per cent on 13 December, after the Conservative Party won the UK General Election with an 80 seat majority and retained Boris Johnson as prime minister. 

While this marks the end of the Jeremy Corbyn threat that was looming over the UK, what is the outlook for the trajectory of fixed income assets in this current landscape?

Several in the industry stress that yields on gilts will rise as demand for UK government debt falls. 

Gilt curve 

Marcus Brookes, chief investment officer at Schroders Personal Wealth says:  “Investors are likely to increase their holdings of higher-risk rated investments such as company shares, and reduce allocations to lower-risk rated investments such as government bonds.”

He adds: “Prices follow demand, so I would expect share prices to increase and bond prices to fall.”

Many in the industry expect the gilt curve to steepen as demand for longer-term UK government debt diminishes. 

Bond prices and yields have an inverse relationship. 

An increase in demand for bonds, pushes the price of bonds up.

Interest rates must fall then to ensure the newer bonds are as attractive as the the older bonds with the same maturity.

Mohammed Kazmi, portfolio manager for the Absolute Fixed Income team at UBP says: “The Gilt curve could also steepen on fiscal expectations, with the front end likely to hold steady as we do not expect the Bank of England to turn hawkish as we still have a trade deal to be agreed.”

Gilts are typically regarded as safe haven assets. Higher yields typically implies a more negative economic outlook, and the converse applies for a shrinking yield, as investors flock to riskier assets in the hope of achieving greater returns. 

Lower yields however mean that the economy is performing better than anticipated, and interest rates must rise due to inflationary pressure caused by economic growth. 

Chris Jeffery, head of rates and inflation at Legal & General Investment Management, says: “The biggest impact of the election is likely to be seen in the performance of inflation-linked securities.”

He adds: “Given the rally in the pound, and the removal of the risk of a fiscal splurge under Labour, we expect a sharp fall in UK break even inflation as the day unfolds.”

But James Mashiter, portfolio manager of fixed income in SEI Investment Management Unit, warns that a shift in fiscal policy could see some additional term premium priced in over the next few years, which would negatively impact total returns on UK government bonds.

 “With the narrative on fiscal policy now shifting, the gilt curve could see some additional term premium priced in over the next few years, which would negatively impact total returns on UK government bonds.”