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Fund focus: QE and euro-crisis have seen gilts enter new territory

While fund managers are often keen to highlight ‘unprecedented’ periods for their asset class, gilts have genuinely entered virgin territory in recent months.

Ten-year yields on UK government debt dropped under 1.5 per cent in July, hitting the lowest point since Bank of England records began in 1703.

Reasons for this decline are well known, ranging from low interest rates to forced buyers through quantitative easing to the ongoing flight to safety from the eurozone.

While understandable, such a rush of money has led to fears of a growing bubble and predictions of its imminent bursting.

So far, however, yields have continued to grind downwards and several managers who attempted to short gilts through 2011 were badly hit.

Nine of 2011’s best-performing funds in the UK had a gilt focus and this return dominance is not just short-term: gilts have outperformed shares now for 20 years, according to the latest BarclaysGiltEquity Study, producing real annual returns (with income reinvested) of 5.9 per cent compared with 4.8 per cent for equities.
Balancing this out, however, with inflation at around 2.5 per cent, investors buying gilts at these levels are locking in negative real returns.

Threadneedle head of fixed income Jim Cielinski says current low yields could stay in place for years due to the UK government’s reflationary policy.

He says: “For us, you have to be very wealthy to take no risk in bond portfolios at present, with current yields offering negative real returns, no hedge against inflation and therefore very little value.”

Such a backdrop presents major conundrums for managers in the UK gilt sector, with many resigned to extracting short-term value and protecting against any sudden rise in yields.

Mike Amey’s Allianz Gilt Yield is among the strongest performers in the peer group, up 50 per cent over three years to mid-September.

In recent months, he has been adding to index-linked exposure, seeing this as better value than traditional gilts and also expecting inflation to remain stubborn due to ongoing QE.

Perhaps the most bearish manager out there on gilts – aside perhaps from Pimco’s Bill Gross and his nitroglycerine soundbites – is Ian Williams, who runs the City Financial Strategic Gilt fund.

Williams has long said gilts and US Treasury bills have the feel of tech stocks at the height of the dot.com boom and his performance has taken a serious hit as yields continued to drop, with Strategic Gilt bottom of the pile over one, three and five years to mid-September.

He says: “Manias do occur in markets from time to time and this has the feel of one. Furthermore, when the inevitable bond bubble does burst there will no way back – unlike the dot.com boom where at least some winners did emerge from the crash, such as Google, Apple and Amazon.”

For Williams’ fund, this overvaluation of government debt presents a major problem and he has looked to avoid what could be serious capital losses when bubble eventually bursts.

He says: “As a result, we took a view that due to the risk-reward characteristics on offer, a safety-first policy aimed at safeguarding capital was more important than chasing gains from an already extended asset class. This has meant missing out on some gains but the alternative is to take undue risks in an asset class that is overvalued on any historical measure.”

Like many investors, Williams highlights the current asymmetric risk profile of gilts, with limited upside but massive potential downside.

“There are two main ways we could see a sharp rise in gilt yields – if some kind of fiscal union emerges in Europe, which should see the hot money that has come into gilts go out again, or if the US housing market continues its recovery. Should the latter happen, it puts the Fed in an impossible situation given Ben Bernanke’s pledges to keep interest rates low. I would highlight the Fed’s policy U-turn back in 1994, which caused a 25 per cent drop in the gilt market, and see similar downside risk today.”

Even if there is no sharp rise in yields, Williams questions why investors would want to own these assets when they could get 5 per cent or 6 per cent from the UK’s largest blue-chip equities like GlaxoSmithKline or Vodafone.

While few other bond fund managers are advocating a move into gilts at such expensive levels, many believe current yields are warranted given the background.

Fidelity’s Ian Spreadbury is unconvinced of the bubble argument, citing ongoing economic difficulties.

Spreadbury says: “Quantitative easing and forbearance are probably creating economic inefficiencies and instability that will one day need addressing. Yet the scale of the remaining debt problem continues to tempt central banks into measures that buy time in the short term, while forsaking longer term risks. It is clear we are several years away from a higher base rate and also that capital markets will remain highly volatile with substantial tail risk. This type of environment warrants low gilt yields, even if they have been pushed a little too far by recent safe haven flows.”

Meanwhile, Bestinvest senior research analyst Robert Harley said gilt yields should broadly equate to nominal GDP growth, so look expensive on such a simplistic measure. But, he notes, low yields are implying years of low growth and negative real interest rates, which chimes with the current macro consensus.

He says: “Gilt bears will argue the rise in forecasts for the UK’s fiscal deficit is another nail in the coffin for creditworthiness and potentially a threat to yields. But investors seem prepared to focus more on the continuation of weak consumer demand and the threat of deflation in a deleveraging world.In addition, while QE may ultimately have inflationary consequences, it can increasingly be seen as a monetary instrument to forestall any rise in yields, thereby enabling these lower levels to support consumption and investment.”

Whether we are in a bond bubble or not, Harley believes it would be appropriate for yields to remain at low levels for the foreseeable future.

In terms of investing in the asset class, he also notes the asymmetric risk/reward profile and said the only winning scenario is outright deflation.

Harley says: “If we reference the Japanese deflationary experience of the last two decades, their 10-year government bond yields rarely traded below 1 per cent yields.This suggests that even in this more extreme outcome, a 1 per cent yield on 10-year gilts is likely to present a floor.”

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