defend the indefensible

Ashcourt Rowan's Stephen Walker admits it is easy to bash gilts on a poor return/low-yield argument but says that is not enough to keep them out of an investor’s portfolio.

defend the indefensible


Whenever gilts are discussed they are nearly always maligned with the argument revolving around how low gilt yields are, how they will inevitably rise over time and that there is a good chance that after inflation returns are zero or even worse.

Normalisation of yields

I would accept that with all likelihood all three of those arguments are well-founded and in time will be proven accurate. Given that, why do we intend to not only rally to the defence of gilts as a valid asset choice for investors but also to advocate the most maligned part of the market, long-dated gilts?

Chart 1 shows how the UK gilt yield curve has changed over the past decade or so. The dark blue line is the yield curve at the end of the first quarter 2013, the light blue line at the same point in 2007 and the grey line at the same point in 2002.

The anti-long-dated-gilt camp usually bases its arguments on a normalisation of yields but while the sensitivity to higher
yields is greater, the adjustment looks much smaller than that needed at the short end of the curve.

Additionally, the steepness of the yield curve means that investors are being compensated for the added interest rate risk, something that was not the case in 2002 and 2007. This means that unless the yield reversion happens particularly quickly, the outcome is unlikely to be as bleak as some investors fear.

In a 2004 academic paper he co-authored when Professor of Risk Management at Cass Business School, Harry Kat eloquently demonstrated why these arguments are valid. He may have been talking about the US Treasury bond market and it may have been during the previous spell of ultra-low interest rates but in my view the arguments are similarly valid.

There appear to be few core inflationary pressures in the UK so while short-term commodity price fluctuations may grab the inflation-related headlines such movements are unlikely to affect the long-term inflation expectations that are a major driver of long-dated gilt yields.

Finally, in the absence of a material move up in Bank of England base rates – which also seems unlikely given the ongoing fiscal squeeze – it is hard to see how the yield curve can become much steeper than it is currently.

Zero real yield

At least officially, the Bank of England still has a 2% medium-term target for CPI and although there is increasing talk about relaxing this target when circumstances require it, the commitment to keeping long-term inflation expectations relatively well anchored in the 1% to 3% area is likely to remain. On that basis, long-term gilt yields look to offer a zero real yield or possibly a fractionally positive one.

On balance, the deflationary forces in the UK such as fiscal austerity appear more structurally entrenched than the inflationary forces of fluctuating domestic bills and petrol prices. The real inflation threat would surely come from an overheated economy with excessive aggregate demand; all things considered it hardly seems right to be fretting about that at the moment.

Well-balanced portfolio

Were there to be some meaningful inflation shock that impacted on long-term inflation expectations does that imply a negative real return on gilts? Of course it does, but then so what? A well-balanced portfolio should include other assets that would benefit from such circumstances and the fact that gilts would probably fare badly is hardly a valid reason not to include them. The global economy could have a renewed downturn that drags stock markets down materially; is that a reason for not having equities in your portfolio? Of course not, and the same line of logic should apply to gilts.

The most vocal advocates of short-dated gilt exposure tend to be managers of bond funds and from their point of view it is an entirely sensible argument. The magnitude of potential losses on long-dated gilts do indeed have the potential to be much greater than the possible upside so the risk/reward appears highly unfavourable.

Investors usually expect their bond funds to do a good job of protecting their capital so it is easy to see why the typical bond fund manager would favour short-maturity bonds with a low sensitivity to changes in the yield curve.

Within the fixed income space, we would view the reward for taking credit risk on balance to be more attractive than the reward for taking interest rate risk. In light of that, why do we believe investors should consider flying in the face of such logic?

The answer is quite simple. The manager of a bond fund has one set of considerations; the manager of a multi-asset portfolio needs to think about things very differently. Where a bond fund manager can avoid long-dated gilts because of the mark-to-market risk to capital values, a multi-asset manager should have other assets that would counterbalance such declines among their gilt holdings.

Where a bond fund manager can look at a 30-year gilt and see an unattractive risk-reward, a multi-asset manager should focus on the (currently) attractive portfolio risk reduction characteristics. Hopefully you get the idea.

Chart 2 illustrates how long-dated gilts appear to have become increasingly structurally negatively correlated with UK equities since just prior to the 2008 financial crisis. A similar pattern can be seen with German bunds and US Treasuries and appears to be part of the whole risk-on/risk-off mind set of investors; as soon as there is a negative growth surprise, long bond yields fall and vice versa.

The increased activism of central banks and an apparent willingness to keep interest rates lower for longer appears to be reinforcing this in the minds of investors. If you look at different maturity government bonds you will find this characteristic becomes more apparent as you increase the maturity. This implies that the longer dated the bond, the better its portfolio risk-reduction characteristics are.

Higher voltility

A final boost to their role in a portfolio risk context is the typically higher volatility of longer-dated bonds. Allied with a negative correlation, higher volatility implies greater portfolio risk reduction benefits and this case is boosted still further as chart 3 shows that increased volatility is broadly coincidental with increased stock market volatility that is more risk reduction not less and when you most need it.

It is worth noting that these views are not set in stone and if either the yield curve became much flatter or the opposite behavioural relationship with equities changed then many of the arguments in favour would fall away.

At present it appears difficult to envisage the first of these happening and the second would appear most likely to occur if the UK lost its place among those nations whose bonds are considered safe havens. Notwithstanding recent and potential future credit rating downgrades, while the UK has a government committed to so-called fiscal austerity the latter appears fairly unlikely as well.

To paraphrase Bill Clinton’s successful 1992 election campaign slogan: ‘It’s the portfolio, stupid’.



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