Is now the right time to dip a toe in the gilt market?

The last few years have been difficult for gilt investors. During this time we have spoken with many advisers and asset allocators, generally pointing out a short duration approach was one to consider, or in fact that it may be better to diversify out of UK assets into global bonds.

The main reason was that we felt gilts close to zero yield offered very little long-term value to an investor, as these offered no income and did not compensate investors for the interest rate risk they were exposed to. The global post-Covid response of mass monetary and fiscal expansion, high inflation and eye-watering supply has seen gilt yields skyrocket. This has suited both investors and our strategies, as we have been running a short duration stance versus our benchmarks and we have been underweight gilts versus overseas bonds.

We are now 18 months through the hiking cycle, and we believe that we are closer to the end than the beginning of that cycle. July has seen the Federal Reserve (Fed) and the European Central Bank (ECB) raise rates by 0.25%, but despite continuing to cite their inflation concerns, both have now moved to a data dependent approach. Many market participants, us included, feel that the Fed and ECB could now be in a ‘pause’ phase for interest rates as it seems very likely that both economic regions will see headline inflation move firmly below base rates in the coming months. By contrast in the UK, even after the 0.25% at the start of August, we believe that the Bank of England (BoE) will need to raise rates again to help combat inflation that remains stubbornly high. The accompanying monetary policy report and Bank rhetoric will be key, with the BoE’s credibility still at stake.

After the upside UK inflation surprise in June and the shock 0.50% hike by the BoE we saw the gilt market price a profile of interest rates peaking at 6.5% and as a result gilt yields flirted with 5.00%. We felt that this was a great opportunity to buy gilts and duly took our funds to a long duration stance and closed gilt underweights in global funds. Where investment mandates permitted, we generally overweight the UK on a cross market basis. Conversations with clients around extending duration – where they were comfortable with volatility – became more frequent.

Since June we have seen some tentative signs that leading indicators are beginning to slow. Headline inflation continues to fall, unemployment rates are rising, and Purchasing Managers Index’s are contracting. However, core inflation remains high, wages are strong and consumer confidence is robust. We would argue that the latter are lagging indicators and as the lagged effect of interest rate rises begin to bite harder, we will see services demand cool in the second half of the year. Also, as we approach year end, we believe the UK is very likely to see real interest rates (interest rates less Consumer Price Index) move into positive territory, which will mirror that of the Fed and ECB.

One thing we can be certain of in the second half of 2023 is continued volatility. Many fixed income investors over the years have not been accustomed to extreme volatility. However, as an active manager, we see this as a key ingredient to adding incremental value. Our key philosophy within government bond strategies is to capitalise on relative value opportunities. One of the most attractive features of our asset class is that assets are in abundance (helped by excess global supply) and transaction costs are minimal.

The question we always get asked is where we think the terminal rate in the UK settles and when is the right time to buy gilts. Our view is that in a non-quantitative easing world, base rates should broadly track nominal GDP expectations. If we assume that the BoE achieves its 2.00% inflation objective (and it has a reasonable track record), and that trend growth in the UK is somewhere between 1.50% to 1.75%, then we arrive at a terminal rate of 3.50% - 3.75%. Therefore, if one can buy gilts close to 5.00% in our opinion that is a decision that offers good long-term risk reward characteristics and for that reason our toes are firmly wet!

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.