How attractive are gilts vs US and European government bonds?
The key issue that the UK faces is that its inflation problem is the most acute with the weakest of the central banks attacking it. Markets’ lack of confidence in the Bank of England (BoE), combined with significant supply and quantitative tightening, makes it very difficult for fast money accounts to hold long term positions. On the flip side, from a longer-term real money investor perspective, gilts are now starting to look fundamentally good value, specifically at longer maturities.Yields on 30-year gilts are about 4.60% per annum. Nominal GDP in the UK has seldom been above this level and if the BoE can achieve their 2% inflation goal then this translates to a real positive return of 2.60% p.a. Compare this with the US and Europe where equivalent real returns would be sub 2% and sub 1% respectively.
What part of the curve looks the best value?
For a number of years, we have been running short duration versus our benchmarks and underweight gilts on a cross market valuation basis. However, in the last few weeks we have been lengthening our duration stance and moving overweight UK assets. Gilts are now at the cheap end of the range versus their overseas peers and we feel that we are most protected at the longer end of the yield curve for the time being. If inflation turns out to be stickier than expected then there is a risk that base rates could go to 6%. However, in that scenario it would be very unlikely that you would see longer dated yields rise above 5%, due to the impending economic downturn. Hence with 30-year yields at 4.60% we feel that there is less upside risk than there is at say the 5-year point on the curve, the yield level at which tends to track base rates.
Where do the risks lie?
The market is priced for rates to move to almost 6% now and I feel that this may be a stretch too far for the BoE, especially as the profile for inflation will continue to be lower due to base effects. This will move the real rate (base rate minus inflation) into positive territory; this, in the past, has tended to be the point at which central banks stop raising rates (post Global Financial Crisis). Also, with the level of yield on offer, government bond portfolios can now withstand a move higher in yield and still deliver a positive absolute return over the next 12 months. As an example, short-dated yields would need to rise to approximately 7% for a short-dated gilt portfolio to deliver a negative return from here. This positive yield environment is hard to ignore and, if you think that central banks are close to the end of their current rate cycle, then adding some duration is possibly the correct decision. Hence our view that it might now be worth slowly dipping a toe in the water.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.