UK government bonds set to diminish in popularity

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.”

“More than the UK”

Others in the industry note that the future of gilts will be more aligned with other global factors, rather than solely be influenced by UK factors. 

Kevin Boscher, chief investment officer of Ravenscroft says: “Slowing global growth, disinflationary secular forces, central bank reflationary policies and the 'search for yield' will exert downward pressure on sovereign bond yields and support credit markets.”

Mr Jeffery echoes this view and says: “It’s worth stressing that the news on the US-China trade deal is just as important as the election in driving gilt yields.

"Donald Trump and Xi Jinping probably have more impact on the pricing of UK debt than Boris Johnson and Jeremy Corbyn.”

Friday 13 December, the day of the election result coincided with China and the US reaching phase one of the long anticipated trade deal between both countries. 

The agreement commits China to buying at least $40bn of US agricultural goods annually, tightens protection for US intellectual property rights and bans the forced transfer of technology from US companies. 

Corporate Bonds 

The election result has also brought in question the future of another key chunk of fixed income: corporate bonds. 

Corporate bonds have performed well in recent months, but experts cast doubt whether this will be the case going forward.

Dimitry Griko, chief investment officer of fixed income at EG Capital Advisors, cautions: “The future direction of US monetary policy looks unclear – while concerns about the global economy remain, we also see the potential for stabilisation of growth in the US, which could cause interest rates to rise once again.”

Mr Griko adds: “The high yield corporate space, on the other hand, looks better placed from this point of view, due to its low sensitivity to monetary policy: if rates fall further, it is easier and cheaper for quality companies to obtain financing.

He explains that if rates rise, it will be driven by economic growth which will cause credit spreads to contract and “the continuous hunt for real yield will add further technical support”. 

Ben Lord, manager of the M&G UK Inflation Linked Corporate Bond Fund thinks that a low to negative interest rate environment has forced yield-starved investors to take more credit risk than they would to achieve their income or return objectives. 

“This, combined with accommodative central bank policy, continues to provide a supportive technical backdrop to the sector.”

He adds that investors need to weigh these positives against concerns about an ageing economic cycle, relatively demanding valuations and weakening credit metrics in the US, “where leverage in the non-financials space has reached an all-time high.

“We don’t view credit spreads as being particularly attractive at these levels, although we also recognise that a large price-insensitive buyer base may prolong the credit cycle.”

saloni.sardana@ft.com