The first ever UK government bonds, known as gilts, were issued in 1694, but this fiscal year will mark the largest ever net issuance of gilts, at a time when the Bank of England are net sellers of the assets.
Data from Collidr indicates that around £238bn worth of gilts will be issued this year – a 29 per cent increase on last year.
The UK Debt Management Office recently announced plans to issue £271bn of gilts during the 2024-25 fiscal year – £35bn higher than the current year.
This has led to speculation about how the increased supply of government bonds may affect gilt yields going forward.
Economic theory suggests that increasing the supply of bonds while holding demand constant should put downward pressure on prices and drive yields higher.
In normal circumstances, a sharp increase in the supply of anything would be expected to lead to a fall in price.
A fall in the price of a gilt means the yield is rising.
Josh Davis, investment manager at Dowgate Wealth, says the impact of the increased supply is likely to be most acutely felt in bonds with a longer date to maturity, where he expects prices to fall meaningfully.
Those are not ideal conditions for investing in such a market. The fact the BoE is selling doesn’t help either, and it comes at a cost to the taxpayer.Phil Milburn, LiontrustThe reason the bonds with a longer date to maturity would be expected to suffer any price falls is that those gilts that come to market now would reflect the higher interest rates of today, while bonds already issued lock in the old interest rate.
A bond with a longer date to maturity therefore has locked in the older, lower interest rate for longer, and therefore may be less attractive in a world where newer bonds are being issued at a higher interest rate.
But Robert Alster, chief investment officer at Close Brothers Asset Management, highlights the reason government bonds, including gilts, may find them an attractive asset class right now as the economic outlook deteriorates.
He explains this is because gilts, particularly those with a long date to maturity, tend to rise in value when the economic mood darkens, as investors anticipate a recession would lead to interest rates being cut, which would lead to lower yields on bonds issued in the future, and so increases the attractiveness of the yields offered by existing bonds.
Supply and demand
But the other factor of importance, according to Phil Milburn, fixed income fund manager at Liontrust, is that the gilt issuance this time is happening in the teeth of the Bank of England being a net seller of gilts, following a period after the global financial crisis when they were net buyers, via quantitative easing.
Milburn says: “This year will see the largest issuance of gilts as a percentage of GDP outside of wartime. And those are not ideal conditions for investing in such a market. The fact the BoE is selling doesn’t help either, and it comes at a cost to the taxpayer.”
This is because, as the BoE reduce their bond holdings, they are compensated by the Treasury.
He says much of the issue around there being a guaranteed seller in the market is already “reflected in the price”, and so he regards gilts as a “very attractive” investment right now.
Davis is also positive on gilts with a shorter date to maturity, saying: "The risk-free returns on the shorter dated gilts offer a preferable alternative to cash, given the tax benefits on many of the low coupon issues. The shorter dated the gilt, the less sensitive it will be to changes in the base rate.”
Fahad Hassan, chief investment officer at Albemarle Street Partners, says that while the circumstances he describes above would typically imply that gilts are a poor investment right now, he adds that yields are at near record highs on some gilts, meaning the prices are at near record lows.
If inflation comes down in the coming months, it will overwhelm any yield impact from gilt issuance.Fahad Hassan, Albemarle Street PartnersHe adds that new buyers are finding reasons to own gilts: “The high nominal yields have attracted strong demand from domestic pension funds and insurance companies that need to match long-term liabilities. Overseas investors have also been drawn to gilts, given relatively higher yields compared to other sovereign bond markets.
"The impact on yields also needs to be analysed considering wider macroeconomic factors. High inflation remains the primary driver of gilt yields in the near term. If inflation comes down in the coming months, it will overwhelm any yield impact from gilt issuance.”
A challenge for investors seeking opportunities in the gilt market is to balance the potential high yields on offer now with the capacity for loss if the price of the bonds falls.
Quentin Fitzsimmons, co‑portfolio manager of the Dynamic Global Bond Strategy at T Rowe Price, says as central banks are no longer buying bonds, the outcome could be that yields remain persistently higher than many investors have been used to and limit the capacity for capital gains from bonds.
Price matters
In terms of valuation, Christopher Mahon, a multi-asset investor at Columbia Threadneedle, says that while both the BoE and the US Federal Reserve began to reduce their QE programmes at the same time, gilt prices have fallen by a significantly greater amount than US government bond prices.
And it is due to this valuation metric that he is keen on gilts right now, taking the view that investors who invest now are buying near the bottom of the cycle, despite the challenges faced by the wider market.
Milburn says the key reason to own gilts right now is that in the event of a recession, they will rise in price terms.
But he adds that if one is trying to understand whether gilts are cheaply priced, “one should think about it like this: a 10-year bond should compensate you for inflation, and central banks target 2 per cent inflation, so you should be getting 2 per cent as a yield, then you need to be compensated for the real level of growth in the economy, which is between 1 per cent and 1.5 per cent, so that takes it to 3.5 per cent yield or so, and finally, because it is an investment where you won’t get your capital back for 10 years so you need to be compensated for this.
"That is called the term premium, and usually its about 0.5 per cent. So all in all, the long run yield for a 10-year bond should be around 4 per cent.
"At the moment it’s about 4.5 per cent, so it isn’t far off the long-term number, but we think with inflation coming down and government risk diminished, gilts are an attractive investment now.”
David Thorpe is investment editor of FTAdviser
