Historically, bond fund managers have taken economic fundamentals to be their valuation drivers. Yet two things have changed in recent years; central bank intervention and the impact on rates, and political uncertainty – not just in the UK but around the world – and its ever-growing influence on financial markets.
Enter Brexit, with Zahn calling it the “ultimate political uncertainty”. Willing both sides to reach some sort of agreement, he says 10-year gilt yields would likely rise significantly from today’s 1.5% level once the uncertainty was out of the way. The economy could strengthen, the central banks could start to hike rates and inflation would continue its return.
“We could move to well above 2%, perhaps even 2.5%, which would then allow us to start reassessing the economic fundamentals,” he says.
The flip side, of course, is the possibility of a hard Brexit. While this is not Franklin Templeton’s ‘base case’, Zahn says he is giving more weight to that outcome than he was 12-18 months ago.
“If we have a hard Brexit, you could easily see 10-year gilt yields back down at 50 basis points,” he says, adding that a single event having the potential to cause a 100bps yield swing in either direction underlines the benefits of active management.
Since the fund’s launch, several factors have been at play. The team started with a fairly long average duration exposure. “We felt gilt yields could decline so it was beneficial to be positioned that way. However, since then, inflation has come back quite a bit, so we have brought it down.”
In the past two years, yields should have dipped, but Brexit-induced volatility and rising inflation have together stymied those falls. Zahn says he has been negotiating the sideways environment by making active duration calls within a 50bps range over the past year or so – something his passive peers are unable to achieve.
Beyond duration, two other items in Franklin Templeton’s arsenal include yield curve positioning and the freedom to look beyond UK gilts, if required.
Zahn says he can take a view on where the cheaper and more expensive areas of the curve are, while expressing his views on interest rate sensitivity. The long and the short end are his favoured exposures, given the current backdrop. The long, because it tends to be anchored to longer-term asset liabilities, such as pension funds, whereas the short end is typically driven by the actions of the Bank of England’s Monetary Policy Committee.
“The middle – around the 10 year mark – represents the market’s view, so it tends to move the most, giving you the most exposure, but you can make significant money by putting on curve trades,” he explains.
Another tool at his disposal is the ability to invest in other governments and currencies, though Zahn currently still has sufficient faith in sterling not to do so.
“If we felt strongly that sterling could see another big decline – for instance following a hard Brexit – we could buy and hedge back part of the portfolio in euro-denominated government bonds and pick up a 1% hedging premium, giving you a significantly higher yield than gilts.”
Clearly Zahn recognises there are other asset classes offering higher yields than the UK gilt market. However, he is keen to point out that as the more ‘usual’ negative correlation between gilts and UK equities is coming back – having disappeared since the global financial crisis, it might be time for passive gilt investors to reconsider that exposure, especially given the likely end of the 30-year bond bull market.
“Investors in passive gilts have made a lot of money out of the bull run, but rather than getting rid of your gilts, now might be the time to look at how they are managed,” he says.
If equities bring volatility, investors seeking safer haven sterling exposure, with the flexibility to diversify, might wish to look at gilts in a new, actively managed, light.
Find out more: Franklin UK Gilt Fund