The news from chancellor Alistair Darling that government debt is set to balloon to levels not seen in half a century suggests that investors should re-examine their long-dated gilt holdings. Technically, if the supply of government bonds increases, their prices should fall.
But some contrarian fund managers and advisers now beg to differ and warn against selling gilts, at least in the short-term. They shrug off fears that the issuance of £220bn in government debt will flood the market, claiming that conditions are better than they appear.
In spite of a recent sell-off, 10-year gilt yields are, at 3.5 per cent, still 2 percentage points lower than they were in 2007 when the yield on a benchmark 10-year UK government bond reached a seven-year peak of 5.48 per cent. And yields are likely to fall further, while prices – with which they have an inverse relationship – rise over the next six to 12 months, advisers predict.
As Phyllis Reed, head of fixed-income research at Kleinwort Benson, puts it: “The basic laws of supply and demand don’t always work in the bond markets.”
Proof in support of the bulls’ argument came the gilt auctions on Tuesday and Thursday, run by the UK Debt Management Office. The auction for £3bn of gilts due in 2022 was oversubscribed 2.25 times, while the auction for £1.1bn in index-linked gilts due in 2022 was more than two times oversubscribed.
“Looking at the cover, the tail [how closely grouped bids are] and the pricing, these two auctions were very solid,” says Stuart Cheek, head of UK government bonds at BGC Partners, the firm of brokers.
The strong demand at this week’s auctions has been seen by many as a good omen. But the record level of debt issuance that the country requires puts pressure on the Bank of England to continue buying back gilts as part of its programme of quantitative easing.
The aim of the quantitative easing is to stimulate the economy and avoid further downward revisions to economic growth.
“But the immediate impact of the Budget is to make life harder for the Bank of England,” points out Mike Amey, a sterling portfolio manager with Pimco, the bond house.
With interest rates nearing zero, economic activity weak and deflation on the horizon, the UK’s credit markets have been compared to those of Japan during the financial crisis of the mid-1990s. In this period, long-dated Japanese government bond yields fell.
A jump in savings rates could help the market, as banks would be forced to bolster their debt holdings, says Paul Brain, head of fixed- income at Newton. “We’re still fairly confident about gilt yields,” he says. “And we think new demand will offset new supply and our back-of-envelope calculations indicate that there will be £200bn worth of demand this year.”
Reed, at Kleinwort Benson, urges investors to hold on to longer-dated gilts in the near-term as deflation comes, but then exchange them for index-linked bonds for protection if inflation returns. “I think private investors should stick with deflationary investments in the next six months or so, with a view to increasing their inflation-linked products later on,” she advises.
Financial advisers agree – with many encouraging clients to hold on to long-dated gilts on the basis that interest rates will remain close to zero for some time. Tim Cockerill, head of research at Rowan, says there is little to suggest that the level of gilt issuance has much correlation to gilt performance.
Quantitative easing is also intended, in part, to narrow the spread between corporate bond yields and gilt yields. But it has yet to prove effective: with yields of 9 per cent or more still offered by investment-grade bonds. As a result, investors seeking income have been piling into corporate bond funds for months as an alternative to falling equity markets.
M&G’s Strategic Corporate bond fund, which invests mostly in higher-quality investment-grade bonds from blue-chips such as Roche, Anheuser Busch and Wal-Mart, and offers a variable yield of 4.77 per cent, is up 11 per cent in the past six months.
Meanwhile, Rensburg’s corporate bond fund, which last reported a quarterly distribution yield of 5.84 per cent, has returned 9 per cent in the period, according to Morningstar.
“The excess yield they offer more than compensates you in the medium term for the extra risk,” says Pimco’s Amey. “For a private investor, the corporate bond market looks a better place to be than the gilt market. The only risk is that we go through a further deterioration in the economic background.”
