Gilts are being snapped up at rapid pace by investors, buoyed by the quantitative easing policy. But with popularity ebbing away a good return, and any threat of crisis set to rock the bonds boat, just how safe are gilts?
In 2011, UK gilts returned better than any other bonds in the world except those of New Zealand, paying a full 11 per cent through December. But investors around the world are piling into gilts, because the UK is seen as a safe haven. There is one good reason for this: the Bank of England’s quantitative easing policy (QE) has increased confidence that the market for gilts will be supported. And they continue to pile in, even though yields on ten-year gilts have dropped to about 2 per cent, making them scarcely better in return than the benchmark German bunds.
“It’s not about valuations, it’s about sentiment,” says David Miller, partner at Cheviot Asset Management in London. “It’s a partial vote in favour of the UK, which is seen as a beacon of sanity in Europe.”
The trouble is that gilts have suddenly become so popular again that the return is now below forecasts for inflation, currently at 5.2 per cent in the UK. Foreign investors aren’t concerned, of course, but does it make sense for UK investors to keep buying gilts under these circumstances?
Well, you get your money back for certain, you don’t have to worry about foreign exchange risk, and there’s almost no danger of the so-called contagion from Europe sneaking across the Channel and crossing the border.
“The key element is that the UK has its own central bank, one that is ready to raise interest rates if necessary and to intervene in the bond markets using its discretion, with the QE2 policy,” says Mitul Kotecha, head of global currency strategy in Hong Kong at Crédit Agricole Corporate and Investment Bank. “Everyone thought that QE2 would weaken sterling, but the markets are rewarding the confidence that the Bank is showing by buying gilts.” Kotecha thinks that sterling will appreciate sharply against the euro in the coming six months, so he isn’t worried about currency risk.
There are some issues to bear in mind if you intend to keep gilts in your portfolio for any length of time. First, consider that UK government debt is at about 80 per cent of the gross national product, that unemployment is rising, and that the outlook for growth is less than 1 per cent this year. Confidence in the UK could weaken, and the demand for gilts would be reduced in consequence. A government crisis would have the same effect.
But Cheviot’s David Miller shrugs off these dangers. “The UK is further away from the precipice than other parts of Europe, that makes gilts desirable, and they are an under-owned asset,” he says. Miller and the other gilt bulls don’t ignore the UK’s problems – including the Bank of England’s announcement on January 5 that growth would be worse than expected, and credit would remain tight – they just think things are better here than in most other developed economies. It’s not really such a tough call: Even New Zealand has its troubles.