Not the most savoury of images, but this amalgam of recent descriptions certainly gets the point across. We're facing a mess in gilts, and an enormous one at that. Debt to GDP ratios are rising aggressively. Without a serious reappraisal of the UK's deficit, this could spiral out of control.
Performance of IMA UK Index-linked Gilts vs UK Gilts over 1-yr
Source: Financial Express Analytics
In a recent paper produced by technicians at the Bank for International Settlements, debt to GDP in the UK, at current run rates, could rise to 500 per cent by 2040! We are likely to see £200bn of gilt issuance this year, around the same levels as last year.
However, quantitative easing has paused at best and, if it has ended, there are not enough buyers of gilts around. Add to this a good dollop of sterling weakness and resultant inflation, and we are on a one-way track for gilts yields. The train they are on is the Polar Express and going North fast!
Having said all this, we understand the argument that at this juncture, Gilts offer more of a tactical than a structural play. In other words, they represent a yield pick-up but are not an aggressive buy.
The headwinds that continue to dog the asset class - inflation pressures on the upside; the level of issuance to absorb in the new tax year alone; the ballooning fiscal deficit; a sterling crisis, and policy error - are just are too much to contend with. Also (as if we all need reminding), we have an election ahead. Should Labour stay in power or there is a hung parliament, it does not bode well for gilts.
Furthermore, we believe that index-linkers look unattractive. Due to their lower coupons, they have a higher duration (the bigger the duration number, the greater the sensitivity to interest rates). Inflation would need to rise significantly to cover any mark-to-market losses from that interest rate sensitivity. The spread on investment grade corporate credit has come in significantly, meaning they now remain highly vulnerable to a rise in gilt yields.
Indeed, returns from corporate credit are likely to be derived more from income than capital gains going forward. However, during quarter one and quarter two this year credit should continue to rally, and we particularly like financials where the spreads are wider.
In quarter three, as macro data improves, concern is likely to escalate about exit strategies away from monetary easing, and credit will drift sideways. Higher interest rates and inflation will be realised towards year-end, which is why we are likely to see front-loaded debt issuance as a response to the risk of wider spreads later on.
With monetary tightening lurking, select floating rate notes and some shorter duration strategies should also play some role in portfolios. Finally, for those who forecast a double-dip scenario, then gilts could clearly benefit.
Bryn Jones is manager of the Rathbone Ethical Bond Fund. The views expressed are his own.