Investors should continue to expect gilts to offer long-term diversification for risk assets but need to be wary of a potential dive in the nearer term, according to Gordon Harding, fixed income investment director at M&G, who says ultimately yields could still be pushed lower.
Doubts over the strength of global economic growth have worsened in recent months, most evident in the US Federal Reserve’s decision not to raise interest rates. Many investors have been upping their exposure to bonds in expectation of another rally, including one in the gilt market which is already at lofty levels.
Gilts have traditionally been a good diversifier when stock markets fall and investors seek out areas of perceived safety, as the graph below shows their often inverse relationship with the broader UK equity market.
Performance of indices since 1999
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 1 Jan 1999 and 30 Sep 2015
But government bond yields have been pushed very low in recent years – 10-year gilts are currently yielding 1.91 per cent. With yields so low, there are doubts over whether gilts could protect against market turmoil while a shadow hangs over them in the form of looming interest rate rises.
Harding thinks there is a reasonable risk that this could indeed happen in the short term but adds that longer term role of gilts in a portfolio should be to offer a source of protection against shocks.
“There are two parts to bond risk: credit risk and duration risk. I can’t see the UK government defaulting on its debt [meaning credit risk is lowing]. However, the average gilt fund has a duration risk of about 10 years so that is something investors definitely need to bear in mind,” he said.
Duration indicates the sensitivity of a bond to changes in interest rates. A higher duration suggests funds could hit harder when central banks make their first rate hikes since the global financial crisis.
According to FE Analytics, the Barclays Sterling Gilts index rose 4.45 per cent between the middle of July and the end of the third quarter, compared with a 8.47 per cent loss in the FTSE All Share.
Performance of indices since 14 July 2015
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 14 Jul 2015 and 30 Sep 2015
However, the correlation between gilts and other risk assets has become greater in recent years than historically it has been, Harding says.
“Over the past few years all asset classes have become more correlated than they have been previously,” he said.
“It has been one of the intended consequences of quantitative easing [QE] because it meant cash rates were brought down close to zero, government bond yields have come down and so it has pushed people out of the curve into riskier assets such as corporate bonds and also into high yield and equities.”
“It has had that knock-on effect of people going to buy incrementally riskier assets than would naturally be their normal place. But, correlations do change over time and over time periods.”
Harding says historically, especially during the financial crisis of 2007/8, gilts and equities were very uncorrelated but when QE was launched all asset classes did very well and became more closely correlated.
Performance of indices over 2007/8
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 1 Jan 2007 and 31 Dec 2008
“When the sovereign debt crisis hit in Europe in 2011 you did again have that negative correlation come back.”
However, he says this has been less apparent more recently and argues that gilts still act as a good diversifier although their current lows may prove unsustainable.
“You can make an argument why government bond yields will go lower but there will come a point when they just can’t go any lower,” he said.
“I think they will continue to work as a negatively correlated asset class compared to risk assets. A good example of that is the last quarter when we have seen concern about global growth and worries about China.”
Harding says there are several potential triggers that could drive yields lower, including the European Central Bank (ECB) doing more QE.
“At the moment it is not our base case but I think there is a chance that the ECB does more: it’s around 50/50 chance. We speak to a lot of sell-side economists and strategists and I would say it is pretty evenly divided between them,” he said.
“Head of the ECB Mario Draghi has said he will do whatever it takes to get inflation back up to 2 per cent and so if the eurozone does not rebound as expected we could see more QE there. That will definitely have an impact on the gilt market as well.”
The domestic economy is also an important potential flashpoint, he says, due to the more recent precarious state of the strength of global growth. A weaker economic growth environment tends to be supportive of government bonds.
“We have seen some strength there but tentatively some of the data more recently has been weaker. If that is the start of a longer term trend of weaker growth in the UK and if inflation does not rebound then that could help to drive gilts lower,” he said.
“Also this could go in tandem with a broader risk-off tone in markets. You can make an argument that gilt yields could go lower.”
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