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Gilt complex

Gilts are something people run to in times of trouble, so it comes as no surprise this sector has been popular in the past year, although not so much of late. In January the sector was the fourth most popular in terms of retail inflows, according to statistics from the IMA.

As of April it was in net outflows, with some £500m leaving the sector. So is the time for gilts and Government debt really over? Managers of the funds themselves say it depends on your view of the world. Those believing the global economy is returning to a growth scenario will find little attractive in UK Government debt while for those who believe the worse is not yet over, there is something still to be said for the safe-haven quality of the asset class.

But even for those undecided in their economic view, there are things to watch out for in the gilt market and choices to be made.

From a performance point of view, UK gilt funds certainly have not kept up with other sectors in recent months. Over the three and six-month periods to June 25, the average fund in this area of the market has produced a negative return.

Jeff Keen, co-head of fixed interest at JO Hambro Investment Management, points out that recent yield movements in gilts have made it tough-going for managers in this space. And he is of the belief that by the year-end and into 2010, yields on 10-year gilts are likely to rise, creating further headwinds for managers.

A few months ago, 10-year gilt yields were some 3 per cent and currently they sit at around 3.75 per cent. That 70 basis-point increase in yield equates to around a 5-6 per cent capital loss on such an issue, he notes.

Such a movement in gilt yields in the span of just a few months is considered unusual, although not unheard of, but it does reflect the increased volatility this sector is experiencing. And this has led to a wider dispersion of both returns and investment styles within this once quite predictable area of the market.

Over six months to 25 June, Trustnet figures show the worst performing gilt fund fell by more than 7.5 per cent while the best performer gained almost 3 per cent.

While in most sectors that kind of performance difference may be quite narrow, in the gilt space it can be considered wide. For example, in 2004 the variance in performance is much smaller, with the worst fund gaining 4.1 per cent and the best up 7.1 per cent.

The following years shows much the same trend with most funds gaining similar amounts – in 2007 the best fund returned 6.5 per cent and the worst was 0.7.

Craig Inches, a fixed income manager on Royal London’s Government bonds desk, notes the level of volatility in gilts is some three to four times higher than at any point in the last five years.

He adds: “The more volatile markets are causing some managers to struggle to cope and I do not think the levels of volatility we are seeing will change for some time.”

To tackle the problem, managers may have to change their more historic investment style in this arena or the funds may have to look to give their managers more tools to work with.

It is interesting to note that over the six months to June 25, the only gilt fund to achieve a positive gain is the City financial strategic gilt fund, which uses derivatives and can even go short on duration within its portfolio.

Keen says: “If a manager doesn’t have the scope to look at other things within a gilt fund, then it is difficult to fight against such headwinds as rising yields.”

With the increased volatility and the need for gilt managers to be more active, Inches said the knock-on effect for fund investors in this space is that turnover levels within their funds are likely to rise.

“Historically, I’d say the average gilt fund was turned over around 4.5 times a year with a range of around two to six times.

“I’d say you could double that now,” he explains.

The amount of issuance in the market, with more still to come, is adding to the issues managers must contend with. Inches notes that in the next three years the gilt market is expected to almost double in size. At the same time, also having an impact is the threat that the UK’s Government debt rating will be downgraded from its current AAA status.

Many bond commentators are not of the belief that gilts or even US Treasuries will be downgraded – or if they are, they feel it will not be a significant downgrade.

However, if it does occur, what would it mean to investors in this space? The most obvious answer is that it would create a rise in yields as the expectation would be for the Government to have to offer more as compensation. Such a scenario would make it even more difficult to eke out positive returns from gilts.

But Keen and Inches both note a downgrade does not necessarily mean yields would automatically rise, citing the case of Japan’s Government debt yields as an example that one does not always follow the other.

With so much holding back this sector, why would investors look at what seems to be an unattractive market? It comes back to a view on whether or not we are headed towards recovery or are mired in recession.

Whatever the case and wherever as an investor your outlook on the current market takes you – be it towards riskier assets or safe havens such as gilts – the changing environment means investors need to be more aware of what they are buying.

Gilt funds are not uniform in nature. And while fund selection in this sector may once have been fairly straightforward, that is no longer the case. Looking ahead, it seems likely it will change even further.



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