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A sense of gilt

Amid an almost unprecedented year of financial crisis, 2008 was all about gilts.

With the market environment little improved early in 2009 and caution the continuing feature, another strong year from UK gilts is probable but just how strong is not so easily answered.

Already in 2009, the Bank of England has cut interest rates to 1 per cent and further reductions cannot be ruled out. With the economy expected to contract in the first half of the year and inflation likely to fall close to zero by the summer, there is virtually no chance of interest rates being increased this year.

This will certainly put a cap on how far government bond yields, particularly short-dated bonds, can rise from their current low levels.

Similarly, the spread between market-determined gilt yields and the central-bank-controlled bank rate, tends to widen mostly when there are clear signs of economic recovery and upward inflation movement. It is difficult to see this happen- ing this year.

There may also be other influences on the gilt market than the Bank of England.

The UK Government for example, has opened the floodgates of gilt supply to finance the huge increase in its borrowing. The UK Debt Management Office will auction close to £150bn in new debt in the 2008-09 fiscal year, with a similar borrowing scale likely in 2009-10.

Added to debt incurred under the bank recapitalisation programme (that is, the Government’s pledge to guarantee UK bank debt), there are clear concerns about the ability of the market to absorb all this borrowing.

However, it is our belief that changes in bond yields are driven more by the economic cycle than by the size of government borrowing.

This is not to say there will be no impact. The sharp increase in government debt implies a longer-term funding burden for the taxpayer which could have an impact on the UK economy’s long-term growth rate. Sterling’s sharp drop in the foreign exchange market last year is perhaps reflective of this.

A positive for the gilt market could come from the Bank of England buying government bonds.

This quantitative easing measure would support gov-ernment bond prices and boost the money supply, offsetting the yield-contraction impact of banks selling bonds in order to downsize their balance sheets. It is not clear at the moment that this policy path will be followed, but it is being debated here as well as in the US.

The outlook is hard to predict with any certainty. For gilts, it could be a year where the total return is significantly lower than it was in 2008. However, decent positive returns could still be achieved, depending on how the economic cycle unfolds.

At one extreme, if things continue to worsen and yields gravitate to extreme low levels, our analysis suggests that total returns could be as high as 15 per cent for 10-year gilts, and even higher for longer bonds. Even if UK yields converge to more reasonable, current US Treasury-like levels, total returns from a market weighted gilt portfolio could still be around 10 per cent.

Of course, one cannot discount yields rising and gilts underperforming over the course of the year in response to the increase in borrowing, signs of economic recovery and the floor put under inflation by the declining exchange rate.

However, if the Bank of England keeps rates at 1 per cent for most of the year, then this movement will be limited.

Chris Iggo is chief investment officer, fixed income at Axa Investment Managers


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