A number of fund managers have bought back into UK Government debt this year or have started thinking about it, as tapering of QE in the US and rising markets have driven yields higher.Many investors are preparing for an eventual rise in interest rates and inflation, which adds to the attraction of the asset class, but Hepworth says gilts are the wrong option.
“We see inflation as being benign in the UK over the medium term – not too high and not too low,” he said.
“The problem for us is that the real yields are so small it doesn’t really make much of an inflation-adjusted investment case at this level and I don’t think we would participate in buying back into gilts until yields pushed out further to 3.5 to 4 per cent levels.”
“Obviously higher inflation will erode into gilt-price performance so in the respect that inflation is contained at the 2.5 to 3 per cent level, this still only just justifies gilt yields where they are on the 10-year at 2.8 per cent; that is to say the real return is just positive.”
Data from FE Analytics shows investors in gilts and corporate bonds over the past 10 years have received a far greater return than the UK inflation rate, as shown by the UK consumer price index.
However, the outperformance has faltered in the past 12 months.
Performance of indices against inflation
Source: FE Analytics
Inflation, measured by the consumer price index, fell to 2 per cent in December from 2.1 per cent in November, meaning that it doesn’t seem to be an imminent threat.
Figures out on Tuesday are expected to indicate that January’s figures will remain low or even fall to 1.9 per cent, marking its lowest level in four years, and could even continue to fall through 2014, according to Samuel Tombs, UK economist for Capital Economics.
“CPI inflation looks set to fall below the 2 per cent target in January for the first time since November 2009. And since the recovery does not seem to be causing price pressures to build, we think that CPI inflation could ease to about 1 per cent by the end of the year,” he said.
However, Paul Warner, investment director of Minerva Fund Managers, thinks the UK could see a significant rise in the rate of inflation within two years, because the full effects of the Bank of England’s programme of quantitative easing have not yet been fully felt.
“This is a huge financial experiment and it’s hard to predict exactly what’s going to happen,” he said.
“In 2016 we could see a rise in the rate of inflation to 5 or 6 per cent, nothing like the 1970s but still significant for investors,” he said.
“What QE has really only done is create inflation in asset prices. Deposits have increased but the banks have not lent these deposits out into the real economy.”
“If that starts to happen and the economy is doing well, there’s the potential for markedly high inflation.”
“In that case the old-fashioned answer I’d advise investors to do would be to get out of conventional gilts and buy inflation-linked bonds, but I wouldn’t advise investors to do either of these yet.”
iShares has an ETF that tracks inflation-linked gilts, the iShares £ Index-linked gilts UCITS fund.
Some defensive multi asset funds such as Ruffer Investment Company have also maintained a high weighting to index-linkers.
Hepworth sees floating rate bonds as good mitigation against the inflationary uncertainty.
“Obviously if inflation starts to build higher than our base case scenario, then this would alter the investment landscape for the majority of bonds as rate expectations crept higher.”
“One fund that we particularly like for this environment is the GAM Star Credit Opportunities fund, which invests into fixed-to-floating rate junior financial names which will provide a downside floor as rates move higher.”
Data from FE Analytics shows GAM Star Credit Opportunities has outperformed the sector benchmark since launch in September 2011, returning 35.05 per cent to the sector’s 17.06 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
“If they don’t (i.e. rates don’t trend higher but remain lower for longer) then we can still enjoy the healthy yield pickups over gilts that this fund offers, so it’s a win-win outcome for us,” Hepworth said.
There are also specialist funds that focus on floating rate notes but they tend to trade on premiums; for example, Alcentra European Floating Rate Income is on a 3 per cent premium.
Not everyone thinks investors should be preparing for inflation.
Fidelity's Trevor Greetham recently told FE Trustnet that falling inflation was likely to continue this year, meaning investors would be best off in equities.
“Despite this pick-up in growth, inflation is falling,” he said.
“This is very good for stocks; in some respects we are back to the 1990s.”
“During that time there were quite a few economic expansions, but inflation was falling. The reason this is happening today is because we have lots of spare capacity in the economy.”
“Data shows there is 3 per cent of GDP slack, which means we could have 3 per cent faster growth over one year – or 1 per cent faster growth over three years – without triggering inflation.”
“That’s where we are now in the cycle. This dis-inflationary recovery is good for equities,” he added.
