Gilts – The Bear Market has Begun

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The Gilt index is an important benchmark for most UK fixed income investors, whatever their risk appetite.  2017 was a year of modest returns (+2% for the iBoxx Gilt index) but the fact is that we are now well into a bear market which will last for many years.  As at 11th January an investor in the 10 year Gilt index has suffered a period of losses of 370 days since the last peak in August 2016.  That is already one of longest recovery periods in the last 40 years or so.  In other words, the Gilt index has been in a drawdown phase for about 16 months.  Most investors will not have noticed because the equity market has soared over the same period and in any case a drawdown of 4% below the peak doesn’t sound like a lot.  But when the asset in question yields just 1.6%, it will take over 2 years to get back to those highs, unless we see another period of falling yields and rising prices.

So what are the prospects for another rally in bonds?  In our view, it is not a rosy picture.  For the first time in a very long time the fundamentals and technicals of investing in bonds have become aligned.  The global economy has transitioned into a period of synchronised growth, spare capacity is being used up and unemployment is close to the lows seen for many years.  All that suggests inflation risks are on the upside.  Deflation risks are waning and sooner or later this will need to be priced into bond prices. On the technical side, central banks are now winding down their quantitative easing programmes.  This means that Governments will have to finance their deficits from private investors rather than relying on central banks.  The increase in supply of bonds on a global scale to institutional investors runs into trillions of US Dollars over the next few years, made worse by the fact that Governments are now relaxing their fiscal straightjackets, imposed after the financial crisis.

After a period of excellent returns since 2008, Gilts will no longer be a profitable investment and those investors that ventured into Gilts as a way of increasing income from cash could get a nasty surprise when they realise how sensitive Gilt prices are to changes in yield.  With the 10 year yield at just 1.3% compared to an inflation rate of 3.1%, those investors are already suffering a loss in real terms.  But if we get an adjustment back to a positive real yield, the capital loss will be extremely damaging to prices.  For long dated securities, losses could be in excess of 20% for a movement in yield of just 1% and that would be just the start of the adjustment.  That recovery period could stretch into years.

By Jeff Keen

Data sourced from Bloomberg & Thomson Datastream

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