It is fair to say September was a busy month for government bonds. Growing concerns over the sustainability of UK, US and French debt amid large fiscal deficits pushed up yields on long-dated debt, with 30-year gilt yields hitting a 27-year high at the start of the month.
Yields jumped largely because investors are demanding a higher return to lend to countries with heavy borrowing needs. Higher borrowing costs for the state means it becomes more expensive to finance existing debt and harder to fund new spending.
So, is now the time to panic about government bonds, or are fears about the asset class overdone? In this month’s head to head, Phil Milburn (pictured left), head of rates at Liontrust, looks at what is happening specifically within UK gilts, while David Coombs (pictured right), head of multi-asset investments at Rathbones, casts the net more widely and examines whether tariffs are good for US government bondholders.
Phil Milburn, head of rates, Liontrust multi-asset team
Gilts are cheap, the yields on offer are attractive whether measured in nominal or real terms. Index-linked 30-year gilts have a real yield of 2.4%, conventional 30-year gilts are yielding 5.6% – levels last seen in the 20th century.
For those less willing to lend for such a long time to the UK sovereign, the 10-year yield is 4.7%, or 0.6% more than US treasuries with the same maturity. So, the question is are you prepared to lend to the UK over the long term?
Herein lies the crux of the dilemma, the attractive valuations on offer in gilts need to be weighed against the erosion of confidence in the UK’s creditworthiness. The incoming Labour government was dealt a tough hand of cards by the prior incumbents, nonetheless they are playing them really badly. By leaving just under a £10bn buffer, and back-end loading fiscal consolidation, chancellor Rachel Reeves pushed the limits of credibility.
The UK, like many countries, needs to maintain access to the bond markets to refinance existing debt as it matures, and provide the funding for the shortfall between taxes raised and government spending undertaken. The argument that other bond markets are under pressure too is close to disingenuous, also under pressure are those without sufficient fiscal discipline.
The problem is that it is nigh on impossible to tax your way to growth, the UK’s fiscal deficit needs to be dealt with by having serious conversations about what the state can and cannot provide given the UK’s rapidly ageing demographics.
The left wing of the Labour Party can smell prime minister Keir Starmer’s blood and are unlikely to support these difficult decisions.
Remember that Labour’s majority is broad but lacks depth due to the UK’s antiquated first-past-the-post electoral system. In an argument between global providers of finance the UK desperately needs, and those in the Labour Party who have not yet faced the reality of the situation, there will only be one winner. I hope it does not take a financial crisis for a basic economics lesson to be learned.
Some bright amid the gloom
There is however good news, the UK can still control its own destiny. Stronger growth than the current lacklustre numbers, or a surge in productivity, would quickly ease the fiscal strains. The UK does have many leading industries and world-class research, cutting red tape and freeing up trade could help capitalise on these.
Furthermore, any gain in credibility that leads to lower gilt yields creates a virtuous circle of reduced interest costs to be borne on the UK’s debt over the longer term.
Longer-dated bonds have also suffered from recent structural changes in demand with the tsunami of pension fund buying now turned into more of a trickle. Authorities are cognisant of this with, for example, the Debt Management Office adjusting the maturity mix of gilt supply. Additionally, the Bank of England at its September Monetary Policy Committee meeting reduced the pace of quantitative tightening from £100bn to £70bn for the next 12 months, with the mix of sales adjusted so that only 20% is in long-dated bonds.
Bringing this together, gilts are cheap for myriad reasons but do offer great value for those willing to tolerate volatility over the coming months. We run global developed market bond funds and for the first time in many years do find gilts compelling, we retain room to buy more exposure given the risks involved. So, over to you Reeves and the Labour Party, on 26 November – let’s have a Budget with both some reality and some hope.
David Coombs, head of multi-asset investments, Rathbones Asset Management
The US economy is in a strange place. The latest GDP numbers show strong growth, powered by strong household spending and domestic goods production. Yet the immigration crackdown is reducing inflows of people and the skills they bring, inconveniencing businesses.
Meanwhile, the administration is continuing to make cuts to the federal workforce and shortlisting more as a federal government shutdown looms (at time of writing). Unhelpfully, the data isn’t particularly reliable these days.
Then there are tariffs that keep piling up. For now, companies have swallowed most of the cost increases, but there’s been a lot of stockpiling as well, so they may start pushing through price rises in the coming months as inventories run down.
These tariffs, just generally, make it harder for businesses to plan and operate in the US. The recent collapse of privately held autoparts conglomerate First Brands might be a case in point, albeit the company seems to have been run very poorly. Large increases in the cost and reduction in access to vital imported materials and services can rupture operating models and upend strategic investments in plant or research. This is something company investors should keep firmly in mind, whether offering debt or equity.
For government bond investors, however, tariffs are probably a good thing, overall. There’s an open debate about whether they are inflationary or disinflationary – we think they will create a one-off bump to prices and then actually create disinflation over the coming years as the higher prices discourage spending. If so, that’s good for bonds.
Add to that, tariffs generally make economies less efficient, so future growth should be lower. All else being equal, that should send bond yields lower as well. And these tariffs are creating a big slug of income for the government. And this isn’t to be sniffed at, especially given how much the US government is spending and how difficult it has been to rustle up more taxes in the modern era. At roughly 6-7% of GDP, these are the biggest deficits outside of recession or war in modern US history.
The market seems to think the situation is favourable: the yield of 10-year US government bonds has marched downward since the initial shock of the April tariff announcement.
Yet I think this has left US debt looking relatively risky. The government’s tariff income is in jeopardy because the courts have so far ruled they are unconstitutional. The Supreme Court is set to decide definitively on this issue soon; the government has been allowed to continue levying the higher tariffs in the meantime.
Interest futures are predicting the US Federal Reserve will make four and a half 0.25% cuts over the coming 12 months. That compares with just one and a half cuts in the UK and fewer than one in the EU. There’s a lot of uncertainty out there in every part of the world, but it seems there’s more chance of US fixed-income markets undershooting forecasts and of rates surprising in the UK and Europe.
Widening the net
Because of this, we’ve been spreading our bond exposure wider. We’ve reduced our US treasuries (but not eliminated them completely) and replaced them with more government bonds from a spread of countries. They include developed markets such as Portugal, Norway, Australia, New Zealand and the UK, and emerging market Romania, which has embarked on a plan to adopt the euro.
While the UK is getting a lot of bad headlines at the moment, it’s no doubt focusing minds in the government. Talk of an IMF bailout is hysterical. And in the meantime, the much higher yields give us an attractive income that should also dampen the capital hit should yield ramp up further.
One area we are generally steering clear of is corporate debt. Global spreads on both investment grade and high yield are trading lower than they have since before the global financial crisis. There’s very little margin of error here. Is it because many companies seem to have better balance sheets than governments?
Or is it because investors are pushing bond prices ever higher as they try to lock in yields before expected rate cuts?
We prefer to hold shares rather than equity-like fixed income, especially those with high cashflow and little debt. These sorts of businesses should benefit from poor-quality peers failing or ceding ground because of tougher operating conditions.
This article originally appeared in Portfolio Adviser’s October magazine
