Over the past three years, retail investors have ploughed a net £1.3bn into the IMA UK gilt sector, suggesting that fears over the UK economy remain high on the agenda.
Since the collapse of Lehman Brothers in September 2008, there have been a number of reasons for investors to increase their allocation to AAA-rated government debt. Primary among these has been the climate of fear that has gradually replaced the short-term panic of the financial crisis.
A result of political stalemate in the US and sovereign debt problems in southern eurozone countries is that markets have had plenty of fuel to feed the uncertainty. This has caused top-rated government debt to gain in appeal, despite poor underlying public debt dynamics and a negative real return from the assets themselves.
Rowan Dartington head of collectives research and FE Adviser Fund Index panellist Tim Cockerill says: “It is more likely to be a safety play than a tactical decision. We have not had anything like what people would call normal market conditions in recent years.”
Investors looking at government debt markets are also able to invest in index-linked bonds, where the principal payments are adjusted in line with changes to the retail price index. This means, unlike traditional gilts, they offer protection against rising inflation.
This has been a concern for investors in recent years. RPI inflation hit 5.6 per cent in September, while the consumer prices index, the inflation benchmark used by the Bank of England, rose to 5.2 per cent, 320 basis points above the official 2 per cent target.
Yet there are some potential pitfalls to these strategies. The BoE says the inflation overshoot has been caused predominantly by short-term factors, including the January rise in VAT and increased commodity prices.
It says: “Measures of domestically generated inflation remain contained and inflation is likely to fall back sharply next year as the influence of the factors temporarily raising inflation diminishes and downward pressure from unemployment and spare capacity persists.”
If this analysis proves accurate, then investors in index-linked government debt could be in for a nasty shock. This would be particularly exacerbated by the fact that a significant proportion of the flows into the sector have occurred since the start of 2011, when inflation was already high.
AFH Independent Financial Services head of research Graham Toone says: “T here are other ways of protecting against inflation. We do not tend to like government debt as a whole at the moment. It is very hard to make the case on a valuation basis.”
Part of the problem is that the rally in government debt over recent years could mean the majority of the returns have already been had.
Over the past three years to October 25, the UK gilt and index-linked gilt sectors have returned an average of 23.5 per cent and 27.3 per cent respectively. For traditionally low-risk, low-return assets, such stellar performance belies the depths of pessimism in the market but without a significant disruption to financial markets, it is unlikely to be repeated.
This is not to say there are no grounds on which to challenge the bank’s assertion that inflation will drop sharply from next year. From August 2009, the inflation report has continually predicted, incorrectly, that inflation would fall. Cockerill says: “The Bank of England has been consistently wrong in its inflation expectations. The new chunk of quantitative easing should weaken sterling and provide another uptick in imported inflation, which could mitigate the removal of short-term factors.”
Inflation forecasting has become something of a guessing game in recent years and the sensitivity of domestic markets to macroeconomic shocks has so far confounded traditional models. It remains to be seen if there is still some way to go for gilts.
Data supplied by FE