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The gilt trip

Concerns over government debt levels and credit ratings on both sides of the Atlantic have created waves in the investment world in recent weeks.

These concerns have been transformed into sell-offs in equity markets around the world and have seen yield on the government debt of Greece, Spain and Italy rise sharply, with yields on Spanish and Italian gilts reaching euro-era highs.

In contrast, UK gilt yields hit their lowest levels for 50 years, with 10-year gilt yields down to just 2.69 per cent.

This disparity may illustrate investors’ relative confidence in the UK economy but is not good news for UK gilt investors. UK gilts have had an unusual few years, with yields dragged down as demand rose during the credit crunch before struggling to rise with the recovering economy.

The record low level of the Bank of England bank rate and the £200bn quantitative easing programme have both distorted prices.

But looking to the future, market watchers see current yields as unsustainable and claim the next move will have to be upwards, creating capital losses for gilt investors.

Against this background, many bond managers see little value in gilts and are avoiding this end of the debt market.

Those with flexibility to benefit from gilts’ misfortunes are doing so, with William Littlewood adopting a short position on UK government debt in his Artemis strategic assets fund for example.

The top-performing fund over both three and five years to mid-July is the Allianz Pimco gilt yield fund vehicle and manager Mike Amey is cautious on current government debt yields.

He says investors are currently not being sufficiently compensated for high inflation and the fragile growth environment and is therefore focusing on bonds that offer a real return.

Amey is holding around a fifth of his portfolio in short-dated, inflation-linked securities and staying away from longer-dated bonds due to insufficient yields.

He is also using short-dated futures to protect the port-folio against a fall in capital value by reducing interest rate sensitivity.

Philip Laing:

‘In the long term, rate rises will prove negative for bond investors but in the short term there are opportunities to add value where negative growth shocks unsettle markets. Our approach remains flexible’

He says: “With spot CPI at 4.5 per cent, short rates at 0.5 per cent and the Bank of England still holding £200bn in gilts, the tolerance for higher than anticipated inflation seems clear enough. This may be a good policy framework for dealing with high levels of nominal debt but, as a bond investor, this does not seem like an opportune time to lock into those levels.”

Instead of gilts, Amey says investors should look to other assets and sectors where they are adequately compensated for inflation risk.

He says: “This speaks to intermediate UK index-linked bonds alongside shortermaturity, higher-yielding assets within the UK or beyond, namely emerging markets where real yields are positive. Opportunities still exist – you just have to look a little harder to find them.”
Several other gilt managers have benefited from a similar flexible approach, with Standard Life Investments’ Philip Laing also noting the alarming prospect of rising interest rates.

As manager of the company’s UK gilt fund, he says that in the UK, US and Europe, monetary policy has reached a turning point as the authorities consider raising rates to dampen inflation expectations but risk aborting an economic recovery that has yet to become self-sustaining.

Laing says: “In the long term, rate rises will prove negative for bond investors but in the short term there are opportunities to add value where negative growth shocks unsettle markets. Our approach remains flexible.

“In the UK, gilts look overvalued, given the current and expected levels of inflation, but there is evidence of foreign investors buying. Hence, despite this apparent overvaluation, we are reluctant to take an overly short position.”

Across SLI’s portfolios, the team has also increased exposure, where appropriate, to index-linked gilts as a defensive move.

Laing says: “This position, plus exposure to US inflation-linked Tips, has added value to our portfolios as inflation expectations have increased.”

Gareth Isaac, who managed the top-performing GLG total return bond fund, core plus sterling bond fund and the GLG gilt fund until his departure for Schroders last week, highlights still falling yields as the market rallied strongly in the face of economic worries – despite a raft of negative bond news.

Isaac says: “The rise in inflation is placing a high burden on household budgets at a time when incomes are stagnating. In addition to this, the austerity measures announced by the Govern-ment have yet to take effect and once they do, the economy will deteriorate further. With that in mind, our fund is positioned for a return to falling yields in an increasingly risk-averse environment.”

Roger Webb:

‘Right now, corporate bond spreads, despite widening dramatically in the last couple of months, look fair value at best. Equities look vulnerable again and government bond yields remain ridiculously low’

Swip head of retail credit Roger Webb agrees that the economic uncertainty has led to a much more risk-averse approach from some investors but says this raises as many problems as it solves and adds that UK gilts are not looking like a safe haven.

Webb says: “A number of factors, including the Japanese earthquake, unrest in the Middle East, European deficits and the US debt ceiling issue, have led to heightened risk aversion. These are not normal conditions and the impact of all these factors is leading investors to fear for the global economy. In these circum-stances, many investors have adopted positions that are short of interest rate risk (duration) due to the low-yield/high-inflation environment. This has, so far, proved costly.

“Where do we go from here? The relatively easy money seems to have been made a couple of years ago and we are now in a more complex environment.

“Right now, corporate bond spreads, despite widening dramatically in the last couple of months, look fair value at best. Equities look vulnerable again and government bond yields remain ridiculously low.”

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