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Gilt edgy

Claims that UK Government bonds are ’on a bed of nitroglycerine’ may be overblown but the market has certainly lost its lustre.

Call that an economic recovery? I’ve seen better bounces from a bean bag. Not only has the UK been the last of the major developed countries to emerge from recession, we have had the most anaemic recovery. Perhaps the adverse weather played a part but it is disappointing nonetheless. It is at times like this investors should take comfort from the very international nature of the companies listed on our domestic stock exchange.

The area where our lagging performance does create issues is in Government bonds, or gilt-edged securities as they are popularly known. Some of the gilt appears to have been rubbed off these stocks. Pimco, the world’s biggest fixed-income manager, referred to British gilts as sitting on a bed of nitroglycerine. It was enough to bring a Government spokesman out to defend the state of our national debt.

But we do have a debt problem. Quantitative easing has cost nearly £200bn and is coming to an end. Repaying
this, and the cost of bailing out the banks, will be exercising the minds of whoever is running the country for some time. Whether achieved through higher taxation, cuts in public spending or, most likely, a combination of the two, action will have to be seen to be done if we are to hold on to our coveted AAA status.

You only have to look at what has been going on in Greece to realise that international bond investors can be pretty unforgiving.

It all started with a story that the Greeks were wooing China as potential buyers of a new tranche of debt. Suddenly other buyers evaporated and yields on Greek national bonds flew out to touch nearly 7 per cent – double that of Germany. Remember, both these countries are in the eurozone.

The worries over the state of some eurozone economies has been behind the sinking of the euro itself. Sterling has hardly been robust but we
have made up ground over the single European currency. Holidays on the continent are beginning to look affordable again, even if our exporters
may find life a little tougher when it comes to selling into the European Union.

British gilts have taken something of a tumble in recent weeks. The flight to quality that characterised the aftermath of the Lehman collapse, along with the savage cutting of interest rates, led to a rise in Government bond prices and a restoration of the yield gap for the first time in
decades. Gilts are back above equities in yield terms, partly because of the falls that have taken place but also as dividends have been cut
by companies seeking to bolster their balance sheets.

Even so, with yields of just 4 per cent on 10-year gilts, there is no cause for complacency. A downgrade in our debt rating or a rise in interest rates to head off inflation – not necessarily likely but not impossible either – would see gilt prices tumble further. In turn, this would make refinancing our debt that much more costly, adding to the pressures on the Government as it seeks to contain the situation.

For the time being, the case for investing in gilts looks pretty thin. Perhaps the suggestion that this market might explode is a little extreme
but when big bond managers like Pimco fight shy of buying our debt, perhaps the humble private investor should too. There will be plenty of investors forced to stay in this market – like pension funds, required to meet stringent asset/ liability matching criteria.

Brian Tora (brian.tora@centaur.co.uk) is principal of the Tora Partnership

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