At a time when quantitative easing flows dominate sovereign bond prices, the key reasons for holding them are now questionable, writes James Klempster, portfolio manager at Momentum.
The world has come a long way in 30 years. In 1983, the Cold War was still a major cause of geopolitical tension, Michael Jackson’s Thriller was number one and the world was naive to the dubious charms of the Chicken McNugget.
In those days, inflation (RPI) in the UK was around 5% and the 10-year gilt yielded more than 10%, meaning gilt investors received a real yield of approximately 5%.
How things change. Today the 10- year gilt yields around 2.5% and RPI is 3.1%. This means gilt investors are losing money in inflation-adjusted terms.
Gilts are nearing the end of a 30-year bull market and central banks have engaged in quantitative easing (QE) programmes designed to keep their prices high and convince investors to allocate elsewhere.
What next for government bondholders?
Even before the advent of QE, the yields available from UK gilts and their ilk were meagre. Today, they are downright unattractive.
Government bonds should provide a diversification benefit to portfolios in the sense that they tend to increase in value when the equity market comes off.
The artificial nature of present yields – thanks to QE – was highlighted in June when government bonds sold off as the equity market sold off.
In an era where QE flows dominate government bond prices, one of the key reasons for holding a sovereign bond is now questionable.
Government bond yields are incredibly sensitive to news flow regarding any changes to QE programmes: market reaction to the Fed’s recent tapering warnings was dramatic, with bond yields rising across the world by around 1% – itself a tightening of monetary conditions which caused central banks to spend July allaying concerns about premature tightening of policy.
With the economic recovery so fragile and debt levels still high across the developed world, central banks cannot afford a policy move that would choke off recovery.
While this may mean there are no immediate risks regarding tapering, it does not alter the reality that, eventually, QE will be withdrawn.
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