Has the Attractiveness of Gilts Improved for UK Investors?
Yes. We believe the attractiveness of UK government bonds has improved relative to just a month ago. The concern for many is that the disorderly market volatility that required the Bank of England (BOE) to intervene last week indicates that the risk of these investments may be higher than usual. While we share this concern, we view the higher yields on offer as having improved the trade-off between potential return and risks.
In September, gilt yields rose dramatically. In fact, the 127-basis point increase for ten-year nominal gilts, which yielded 4.1% at month end, was the fourth largest one-month increase since 1900. Said another way, 30-year gilts issued just last year with a par value of £100 have seen their price fall to £55. These dramatic changes were linked to two main factors. First, expectations for the scale and speed that the BOE would need to hike interest rates to address inflation increased almost daily. For instance, the Intercontinental Exchange (ICE) three-month Sterling Overnight Index Average (SONIA) December 2022 future increased from yielding 3.7% at the end of August to yielding 5.0% at the end of September.
The second factor behind the interest rate rise was linked to the UK government’s mini-budget. The budget proposed several tax cuts and estimated the cost of the energy subsidy plan to be £60 billion for the next six months, which raised concerns about long-term debt sustainability and led to a sharp rise in yields. The rise in yields was exacerbated by some pension funds, which held leveraged long-dated bonds for liability hedging and needed to sell in response to margin calls. The BOE then intervened to stabilise the market by temporarily buying long-dated gilts.
But for us, last month’s rate repricing has increased their attractiveness. One reason behind this is that ten-year gilts are now trading in line with their long-term economic fundamentals for the first time in over ten years, based on trailing ten-year UK nominal GDP growth (3.8%). Linked to this is the fact that real yields for most maturities also shifted from negative to positive territory last month for the first time in a decade. The large shift in rate expectations this past month also means the market may be closer to fully pricing in this rate-hiking cycle.
We also expect the market is likely to see stronger demand than typical from a couple areas. One such area is linked to UK pensions, which have tended to see funding positions improve with the rise in discount rates. Many pensions have substantial portions of interest rate risk unhedged and are now in a position to lock in meaningfully positive yields in longer-dated gilts to reduce liability risk. Another area of demand could come from the redeployment of some international growth assets. Many UK investors have benefitted from foreign currency exposures, particularly US dollar exposures.
This year notwithstanding, we also believe UK gilts remain an important source of diversification for pound-based investors over the long term. One way to see this potential is to consider how they performed when equities struggled. Since 1976, there have been ten calendar years with negative global equity returns. Across those ten years, gilt returns averaged 10.5%, with nine years of positive returns. While the correlation between gilt and equity returns may remain high if future inflation readings are higher than expected, we still expect investors will place value in gilts as a source of safety and stability over the long term.
Still, gilt volatility may remain higher than typical in the near term. The BOE’s bond-buying program is authorised until 14 October, and, while its bond purchases have fallen far short of the authorised amount and new rules to protect against chaotic gilt selling may be forthcoming, it is unclear what will happen after the program ends. Even if last month’s volatility does prove fleeting, gilts still face the possibility of increases in rate expectations. After all, the latest data indicate UK inflation increased by 8.6% over the prior year period, and inflation has yet to fall convincingly in any major country that experienced a pandemic-related rise.
Ultimately, we see the rise in UK gilts as an opportunity. Many UK investors have seen their sovereign bond portfolios dwindle, given the low yields that have been on offer for so long. We believe now is a good time for investors that are underweight sovereign bonds to consider increasing their exposure to match their policy portfolio.