Whilst the Deputy Prime Minister’s resignation has been grabbing the headlines, we believe that the Chancellor’s upcoming budget and the movement in Gilt markets is the more interesting recent event from an investor perspective.
For those not following the headlines, long dated UK Gilt yields have been rising and spiked up this week on Tuesday to just under 5.7%. It’s the highest rate of return on a ‘risk free’ bond since 1998.
The media talked of the threat of an IMF bailout and evoked the memory of the Labour Chancellor Denis Healey (remember the eyebrows!), who in 1976 sought an IMF loan, which came with swingeing conditions. Britain is doomed!
Putting The Move in Context
Firstly, whilst online yield charts for 30 year Gilts don’t go back to 1976 you can read the Bank of England’s report of that year which states in relation to long dated gilts:
“At the long end, for example, they (yields) rose from 13 1/4% in mid March to just below 15% at end of April.”
Bank of England Historic Data.
So, in the context of history 5.7% is not a particularly high yield. This chart below shows long duration gilt yields since 1707 which suggests yields of 1% as we saw by 2020 were in fact the extreme outliers, just as the 15% yields in 1976 were. On average yields have been over 4% and were over 5% from the 1960’s right through to the Great Financial Crisis of 2008.
The moves in Gilt yields in the last 12 months have just helped normalise what was an inverted yield curve by end of the Covid crisis, with short term rates higher than long term rates.
As short term rates have come down and long-term rates have gone up, something we expected to happen, we now have a more normal yield curve which rewards investors for lending for longer terms. This is generally a sign of a healthier economic back drop than an inverted curve, which can often be the precursor to a recession. If markets want more interest in the short term than over the long term it can be an indication they expect an economic slowdown in the future. That is now not the case, so it’s not all bad news.
If we look around the world the UK is not unique at all in going through these yield movements. The ‘Bond Vigilantes’ as the fixed income markets are often referred to, have been demanding higher returns on longer dated bonds in the last 12 months in the US, Europe and Japan.
All Charts Sourced from Market Watch
There have been remarkably similar 1% increases in the yields on long dated Government bonds in all these economies. In relative terms the move in Japan from around 2.3% to 3.5% in the last 12 months is the biggest percentage increase, up over 50% compared to the c20% increase in UK yields.
It seems to us that global bond yields are just getting back to more normal levels everywhere.
Why We Won’t Be Buying 30 Year Gilts for Your Portfolios
Surely if we got to a 6% ‘risk free’ return, what’s not to like? Why wouldn’t we just lock that in and give up investing actively in corporate bond markets.
Here are three good reasons why we won’t do that:
A 30 year Gilt is an impractical investment to hold, especially if you are investing for income and getting a bit older
Contrary to what you might expect, you don’t get a c6% cash flow from buying a 30 year gilt yielding 6% today, it is not that simple.
The Government is not yet issuing more 30 year Gilts with c6% coupons (interest) and won’t be for some time to come. Quite sensibly they are issuing shorted dated Gilts with low rates of interest. So, to buy a 30 year Gilt you have to buy one already in issue that matures in 2055. These bonds were issued a few years back with lower coupons, the choice is either a 1.6% coupon with bonds currently trading at around 44p or, 4.3% coupons trading in the low 80p range. Either way you won’t get your 6% annualised return until the bond matures for £1. The return will come part as income part as capital gain.
They are only risk free if you are prepared to hold them for 30 years. I will (might) be 93 by the time they mature!
That’s an awfully long holding period. Over shorter-term investment horizons the capital values of these long duration bonds will be quite volatile. A 30 year Gilt is clearly a better buy today than in 2020 but there is still considerable risk on a 3-5 year view. Even on a 5-15 year view. It will be 25 years before these would be considered lower risk short duration bonds.
The capital value of long duration bonds whips around as bond yields move. For example, if long duration yields went up to 6.5% in the next 12 months, you could expect a c 15% capital loss on one of these bonds.
Of course, the converse will be true if rates fall from here. If you think that perhaps a new Chancellor might do a better job or even be perceived as being able to do a better job such that we got 0.5% drop in rates you would get a c15% capital gain, that would be tax free if held personally.
However you look at this, it is all very speculative. Despite what the media would have us believe, the current position of the UK Government, and indeed several other major Governments, is not down to actions of the current batch of politicians in recent months, rather it is the culmination of almost two decades of very loose monetary policy followed by the re-emergence of inflation. The path out from Government deficits and debt mountains caused by such loose policy is far from clear.
Trump would like to go back to the good old days of rock bottom interest rates again, devalue the US dollar and have tariffs increase tax receipts. Reeves and the Labour Government hope that economic growth and more inheritance tax can boost tax receipts and balance the books. Both are finding out that the ‘Bond Vigilantes’ will most likely have the ultimate say and political ambitions will ultimately have to bend to hard investment market realities.
The steeper yield curve helps our active bond managers increase returns
This is a mathematical fact rather than speculation. If you are running a fund and looking to stay at an average bond term to maturity of, say five years, this inevitably means selling bonds before they mature and buying longer duration bonds again to keep the average steady at five years.
A steep yield curve provides a perfect back drop to do this in and allows you to make a bigger return than the headline yield on the bonds you buy. Nick or I will happily explain this to you if you give us a call, it is known in the trade as ‘carry and roll’ but can need a moment and some explanation for it to sink in.
In essence, if you buy a 10 year bond yielding 6% and sell it before maturity as a 5 year bond yielding 5% (lower down the yield curve), you don’t make 6% p.a. in your 5 year holding period, you end up making 7% p.a. I know it sounds like wine out of water, but the maths does work! The gain made in corporate bonds tends to be even bigger than on Government bonds because the risk of default also lowers as bonds get closer to maturity.
So, we will be sticking to actively managed funds, we may well add more to funds investing actively in gilts as the returns get better and this is generally cheaper to do than investing actively in corporate bond funds.
We do see the recent move up in long dated Gilt yields as a positive sign for future returns from our active corporate bond managers who will inevitably increase their returns from ‘carry and roll’.
You’ll be glad to hear that’s enough on Gilts, who would have thought they could be so interesting. Below Nick looks at some shares in companies that have been helping our returns of late. Regular readers will know that we have been leaning away from the US big caps dominating global indices. Some of this is about risk management, but it is also about seeking greater returns and Nick looks at two great examples where this has worked.
