The volatility in the gilt market has delivered much pain for mortgage and pension professionals, but for some investors it has been a time of plenty.
FTAdviser knows of one fund manager who made a profit of 17 per cent on one gilt trade in 24 hours. That manager didn't wish to be named in this article.
The intention had not been to flip the asset so quickly, but such has been the volatility in the asset class that the price had risen stoutly in twenty four hours, and the potential for a rapid profit proved too tempting.
Those events happened in the immediate aftermath of the “mini budget” under the brief Prime Ministership of Liz Truss, and the gyrations in the market for UK government debt at that time were presented as being without precedent.
Yet the very high yields that were born of Trussonomics resurfaced in the gilt market at the start of June, with yields on some UK government debt actually rising above the levels seen at the time of the mini budget.
Given such volatility, how should an adviser or wealth manager think about the role of gilts in portfolios going forward?
It is first worth examining why bond yields may be rising.
A rising bond yield in the first instance signals a lack of desire to own the asset, because if yields are rising then prices are falling.
And bond prices may be falling because investors are more confident about the economic outlook and so would rather own riskier assets such as equities, or else it can be the result of investors believing that inflation will rise so stoutly that the present value of the income from a bond will be withered by the onset of very high inflation.
The tax cuts and spending plans of Truss’s “mini-budget”, and the apparent view of that government that tax cuts in all circumstances raise revenue, spooked many bond investors who believed the plans were not credible and would lead both to much higher inflation. Conversely, a government facing a revenue shortfall which would necessitate the issuing of more bonds, creating a supply vs demand imbalance that would be expected to push the price of bonds downwards.
Those factors are exacerbated by the Bank of England selling off its holdings of gilts at a rate of hundreds of millions of pounds per month, as part of its plan to unwind the quantitative easing programme which involved buying bonds.
Bumpy ride?
But while understanding the reasons for sharp movements in gilt yields may help one to profit in the short-term, as happened with the fund manager mentioned above, much of the theory which underpins how wealth managers construct portfolios is predicated on gilts being a lower volatility asset class, designed to mitigate the impact of equity markets. So while there may be short-term gains, longer-term questions arise around how to construct a portfolio.
So if gilts are to be a more volatile asset class, albeit one with the potential to deliver outsized returns in the short-term, does that materially impact the structural reasons for owning gilts in portfolios?
Not according to Simon Evan Cook, who runs the Downing Fox range of multi-manager funds.
His view is that gilts are more investable now than “they have been for many years”, as a result of yields being higher.
He says the traditional reason to own gilts in portfolios is to have an asset class that can rise when equities fall.
Evan Cook believes that with yields now high enough, it is reasonable to expect this would happen in the event of a recession, as investors would buy gilts, rather than equities, as a safe haven.
He feels that inverse correlation had broken down for much of the previous decade, as both bond and equity prices were high at the same time, creating a period of time when the structural reason to include gilts in a portfolio made little sense.
His view is that gilts are supposed to be volatile so long as the volatility means they fall when equities are rising, and vice versa.
Ben Seager-Scott, head of multi-asset investment funds at Evelyn Partners, says: “Their structural role remains largely unchanged despite the volatility and the shifting resulting allocations – I think it is important for people to make sure they have a good working understanding of the asset class and its characteristics.
"In particularly, an overlooked aspect is correlation. A lot of people simply assume the correlation between equities and gilts is negative but the reality is it changes over time. Crucially, correlation tends to be negative during growth shocks, but positive during inflation shocks, as we saw last year, to quite painful effect”
He believes the reason gilts performed poorly in 2022 alongside equities, which is not supposed to happen if the asset classes are inversely correlated, is that the bear market in equities was caused by higher inflation, which is also poor for gilts.
But that the next period of equity market sell-off could be sparked by fears of recession, rather than inflation, and in such circumstances, the normal expectation is that gilts would rise when equities fall.
Andrew Hardy, who runs multi-asset portfolios at Momentum Global Investment Management, says the sharp falls in government bond prices generally, and gilts in particular, in 2022 mark a “healthy reset” in terms of valuations, and probably means that the risk to reward ratio is now set firmly in the buyers' favour.
Inflated expectations?
Both Seager Scott and Evan Cook believe that while the yields on gilts are right now still lower than the prevailing rate of inflation, meaning the yields are negative in real terms, they feel that what matters more for the future direction of gilt prices, is the expectation on the direction of future inflation.
Both believe that as inflation will fall in the UK, this should boost gilt prices in the near term.
Guillermo Felices, a global fixed income strategist at PGIM, says the problem for investors considering gilt exposure right now is that while gilt prices reflect a certain amount of additional interest rate rises, if inflation in the UK proves more persistent, then rates would have to rise by more than is currently priced by investors.
In that situation, he expects gilt prices would fall.
Benjamin Benson, head of investment research at AFH, says he likes gilts “more now than for a long time”, but he is very cognisant of the risks as outlined by Felices that rates rise at a quicker pace than is presently priced in.
In order to mitigate those risks, he is presently keeping his exposure to gilts relatively short dated, with the intention of increasing the duration as the inflation picture becomes clearer.
Bonds with a shooter date to maturity tend to perform better when investors biggest fear is inflation, and those with a long time to maturity do best when recession is the major concern.
David Thorpe is investment editor at FTAdviser
