On 5 July, the government issued a two-year bond with a yield of 5.668%. This was the highest for any gilt sold since June 2007, when the government sold £2.5bn of five-year gilts at an average yield of 5.8%. At that point, the UK’s government debt was £745bn. Today, it is £2.5trn.
For investors, particularly sterling-based investors, gilts now have significant appeal. The yield is around 1% higher than equivalent US treasury, and more than 2% higher than the equivalent German bund. Held to maturity, short-term gilts are increasingly a compelling alternative to cash, as high street banks fail to pass on higher interest rates to savers. They may also benefit from the momentum in sterling, which has been appreciating as interest rate expectations have risen.
Retail investors appear to have recognised the opportunity. The latest Investment Association statistics showed that in May, £658m flowed into the government bond sector, with £344m going into the UK gilts sector. Laith Khalaf, head of investment analysis at AJ Bell, said: “It seems likely this is a combination of private investors buying government bonds and multi-asset funds boosting their fixed income allocation.”
Investment managers are also gravitating to the UK government bond market. Mark Preskett, senior investment consultant and portfolio manager at Morningstar, says: “We have been buying gilts, putting some of our cash to work and selling US treasuries. For UK-based investors, gilts are the risk-free asset, and treasuries are in a different cycle.” This corrected a long-held underweight position in UK government debt.
He says that there is still some inflation risk: “The biggest risk for the gilt buyer is that UK inflation stays sticky. As a result, we’ve been increasing our position in UK index-linked bonds as a hedge against the worst outcome.” He admits there is still uncertainty over whether the Bank of England will get inflation under control, but says their base case is that interest rate rises will have an effect eventually.
Mike Riddell, head of macro and unconstrained fixed income at Allianz Global investors, has recently turned bullish on gilts, having been bearish for around 18 months. He said gilts didn’t appear to be pricing in the UK’s inflation problem, nor the “ugly net supply dynamics”. He thought rates would ultimately have to go higher than the market was pricing.
However, in a recent blog, he says recent rising yields had changed the game: “The market is now fully pricing in UK rates going to 6.25% by February next year, where the Bank of England is then expected to keep rates elevated for years afterwards. If the Bank follows this path, we have little doubt that it will succeed in destroying demand, when demand is set to weaken anyway as all the rate hikes since last summer start to bite. This should rein in inflation.
“If UK and global growth slows as we expect, then inflation could well undershoot what the market is implying. When compared to other markets, gilt valuations out to around the 10–15-year part of the curve now really stand out”
However, while bond investors may have been handed new opportunities, rising gilt yields may prove to be very difficult for the UK economy. In June, UK government debt rose above 100% of GDP for the first time since 1961. The most recent Office for Budget Responsibility report said public sector net borrowing was £25.6bn in April, up 86.6% on last year. The debt interest bill is rising at a time when public services are already under significant strain. It is difficult to see a turnaround for the UK economy when it is facing these pressures.
Equally, it makes it more difficult to see progress in the UK equity market. If international investors have a choice between the wayward charms of the UK stock market, and a gilt paying 5.7% over two years, it is difficult to see them picking UK equities. It is worth noting that in the same month gilt funds saw inflows, UK equity funds saw another £1.2bn in outflows. This was the seventh consecutive month where the IA UK All Companies sector was the worst selling net retail sector.
It is only in the past few months that the yield on UK gilts has surpassed that on the UK stock market. One of the UK stock market’s key selling points has been its high dividend yield. If investors can get that income elsewhere with less risk, it removes another reason to hold UK equities. While equity managers will argue that gilts offer no protection against inflation – unlike UK dividends – this argument appears to be falling on deaf ears.
While the high yield on gilts undoubtedly represents a new opportunity for fixed income managers, it raises some uncomfortable questions about the health of the UK economy and may act as another barrier to a turnaround in the UK stock market.
