Is now the right time to extend duration?

Six months can be a long time in markets.

In July 2023, UK Consumer Price Inflation (CPI) reached 10%, the Bank of England delivered its 13th consecutive interest rate hike, taking base rates to 5.0%, and 10-year UK government bond yields were continuing their rapid march higher, eventually peaking at 4.75% in August.

Today, inflation is falling relatively rapidly, the latest CPI print at 4.0%. Yields on 10-year gilts have fallen almost 100 basis points to just below 4.0%, and many economists are now expecting UK base rates to be 4.0% by year end. Despite this rapid fall in bond yields, is now the right time to be considering extending duration?

Yield benefits of short gilts

In July, the macroeconomic picture meant that UK government bond markets were pricing in UK base rates to peak above 6.0%. As a result, shorter maturity UK Government bonds, whose yields tend to track base rates more closely, saw their yields rise aggressively. As the chart below highlights, the yield to maturity on a three-year gilt (UKT 0.125% 30/01/2026), was yielding 0.67% more than an 10-year gilt (UKT 4.5% 07/09/2034).

Chart 1: Yield Maturity Differential

Source: RLAM as at 19/01/2024.

Our observation at the time was that the value for investors in UK government bond markets was biased towards the short end of the market; why would an investor not look to receive more yield for significantly less interest rate risk? In our view, shorter duration strategies were therefore probably better to own than an all-maturities equivalent from a risk and reward perspective – given the higher yield and significantly lower duration (typically c2 years on 5-year gilt indices vs c8 years on the all-maturities version)

…A lot can change in six months

Fast forward six months and the economic landscape is now somewhat different. Inflation has peaked and markets are focused on when, and by how much central banks will cut interest rates. As a result, the yield on offer to bond investors has fallen sharply since July last year. Despite this fall in yields, it is shorter maturity bonds that have performed very well, especially relative to longer maturity bonds (see table below). This is unusual as normally in a declining yield environment, longer maturity bonds would tend to outperform shorter bonds in capital gains terms.

Table 1: Bond yield and returns

*Returns are gross from 12:00 on 30/06/2023 to 12:00 on 19/01/2024, yields as at 24/1/2024

Where next for government bond investors?

Despite yields being lower today than in the summer of 2023, is now the right time for government bond investors to consider switching out of shorter maturity portfolios into longer maturity equivalents and increasing duration?

The first chart shows that at the time of writing, bonds with a maturity of three years now have the same yield to maturity as bonds with a maturity of 10 years. In fact, for bonds with a maturity longer than ten years, the yield to maturity on offer is even higher due to the upward sloping yield curve. This market dynamic is reflected in the table above too, where the yield to maturity on the all-maturity index is now higher than that on the shorter maturity index.

Hence despite yields being lower than last summer, investors no longer suffer a yield disadvantage for the risk of owning an all-maturity portfolio. In our view, the choice between which to own is more broadly balanced; now may be a good time for investors that have predominantly been invested in shorter maturity products to consider switching some of their money into longer maturity products that have a higher sensitivity to falling interest rates, especially if they are concerned about a deep economic recession.

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.