Article provided by Jeff Keen, Head of Fixed Income, Waverton Investment Management.
Back in early 2018, I wrote a piece entitled “Gilts – the bear market has begun”. I pointed out that Gilts had been an excellent investment for the previous 35 years but had peaked in August 2016 and were 16 months into a bear market. That call was perhaps premature, having seen the Gilt index reach a new total return peak in September 2019.
Have we changed our thinking? Most definitely not.
In many ways the rationale for poor returns in Gilts from today is even more compelling than it was in January 2018. But what caused the Gilt market to rally to a new peak? Firstly, the synchronised global growth we saw in 2017 started to peter out towards the end of 2018 and has led to widespread economic pessimism in 2019. More specifically to the UK, the Brexit crisis carried on and on and on.
It has been a rollercoaster ride trying to assess the risks of Brexit over the last year and indeed the forthcoming General Election on December 12th, but it looks increasingly likely that the Conservative party will get the majority it needs to push through Boris Johnson’s deal with the EU. Although that just gets us to the next stage of the Brexit process, we anticipate a positive stimulus to the economy as uncertainty abates.
But politics aside, if we look at where Gilts are trading today (around 1.1% yield for the aggregate index), this remains well below the level of anticipated inflation. Forward swaps predict that UK inflation will be 3.5% between 2024 and 2029. Even if we assume this is too high and trust that the Bank of England will be successful in bringing inflation down to the 2% target level, Gilts will still destroy real wealth over the medium to long term. It’s hard to see any good reason to buy Gilts on the basis of the return offered to final maturity dates.
Further, when we consider the risk that needs to be taken to achieve that return, it has gone to much higher levels since early last year. The sensitivity of Gilt prices to yield (referred to as duration risk) has increased by 10% since January 2018 while the yield on Gilts has fallen from 1.6% to 1.1%. So the movement in yield which would be enough to wipe out 1 year’s total return has fallen by 38% to just 0.085%. To put this into perspective the Gilt yield rose from 0.75% to 1.1% in the last 5 weeks, losing 4.9% – equivalent to over 4 years’ return. So it’s clear that you have to risk a lot of capital to collect small levels of income in the Gilt market.
So what about investment grade corporate bonds? Unfortunately this will not be a hiding place if we see the kind of yield shift that we think is possible, perhaps likely. Duration risk is high in this market too and the correlation between corporate bonds and Gilts has been over 80% in the last 3 years. But the real worry in the credit markets might concern the huge flows of capital into bond markets, especially the billions poured into passive bond indices, which are full of the most indebted companies. As yields fell, investors collected their income and made capital gains. When those gains turn into losses, we expect investors to sell and the question is whether the markets can handle a mass rush for the exit. It could get ugly.
By Jeff Keen
Head of Fixed Income
As at 11.11.19
The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.
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