while equities have fallen for the past three years, the UK gilt sector has returned 22.3% and should do well in 2003 despite falling yields
With the UK equity market down three years in a row, investors looking for steady returns could well consider the pros of investing in the UK Gilt sector.
Compared to the UK All Companies sector, which over three years to end of January 2003 has fallen 37.18% bid to bid, the UK Gilt sector has returned positive growth of 22.3%, an outperformance of 59.48%.
Over 12 months to the end of January the sector has outperformed the UK All Companies by 36.18 percentage points, with gilts producing a positive return of 8.02% and UK All Companies falling 28.16%, bid to bid.
The gilts sector also stacks up well compared to UK Other Bonds, which over three years has produced a bid-to-bid return of 10.36% and over one year has fallen 5.45%.
Over three years to the end of January 2003, the best performer in the sector has been the SocGen Institutional Sterling Bond fund, which has returned 27.89%, compared to the sector average of 22.3%. It has achieved this with an alpha of 2.54, compared to the sector average of 0.95.
The fund has managed this outperformance with below average volatility, posting a beta of 0.95, compared to the 0.97 sector average. Stephen Peirce, co-manager of the fund, said it has outperformed because it has resisted the temptation to make overly-large bets in the sterling market.
Peirce said the UK market is dominated by the pull between the fundamentals and the technical aspects of the sector.
He said many managers have made the mistake of backing their fundamental views too heavily and have been caught out when there are technical changes in the market, such as the proposed removal of the minimum funding requirement for pensions, which has already led to a reduction in institutional demand for gilts.
On the SocGen fund, Peirce said he and co-manager Paul Rayner take smaller, more calculated bets, so as not to be blindsided by such changes when they come around.
'We look first at the macroeconomic scene and make our own forecasts and then we go to the market and extract information, on, for example, where interest rates are going and how much risk premium the market is pricing in,' he said.
When they have analysed both their own views and those of the market, Peirce said the fund invests to exploit what it feels are the largest price discrepancies.
He does not make huge bets due to risk of market capitulation if it goes wrong, instead investing according to the shape of the yield curve and allocating overweight and underweight sector positions.
He said: 'We look at trends in the market using technical analysis to get an idea of momentum. We also look at new regulations, changes of indices, new issues of gilts and how it will impact the yield curve, regression analysis, and finally what is happening in the repurchase market and in futures stocks.'
At present, Peirce said the fund is marginally light the market. This, he said, is driven by the uncertainty in Iraq and the forced selling of equities and buying of bonds by the insurance market.
As a result, the fund is overweight middle duration rather than in the short and long-end of the market.
Looking forward, Peirce thinks interest rates are set to rise and he does not rule out another 0.25% rate cut in the short term.
He said: 'Before the recent rate cut to 3.75% we had forecast rates would be up to 4.5% at the end of 2003 and at present we are sticking with this view. The recent rate cut could be reversed very quickly and central banks are on a reflationary track.'
This view goes against the consensus, where expectations centre on rates staying below 4% until 2005.
Closely behind the SocGen fund is Andrew Argyle's Schroder Gilt & Fixed Interest fund, which has returned 25.29% bid to bid over three years to the end of January and 7.66% over one year.
Argyle said his style is essentially not to rely on one source for adding value, which he said in many cases is a reliance on duration exposure.
He said: 'We do look at duration exposure but we also look to place an emphasis on yield curve exposure, stock selection, credit and asset allocation. The aim is to diversify the risk across the portfolio in a wide range of different decisions, rather than just guessing on one.'
Over time the fund does place a varying emphasis on different decisions and at present Argyle said the fund is constructive about credit and as government bond yields are fairly low he is quite conservative about its duration exposure.
With break-even inflation rates being very low at present, Argyle said he prefers index-linked gilts to conventional gilts and the balance of risk suggests index-linked bonds will outperform, particularly in an environment where nominal yields should be higher.
He said: 'Yields are historically low, they are at their lowest levels for decades. In this environment I don't expect gilts to outperform a lot in 2003, however, I don't see there being a sell-off either as I can't see a strong rebound in equities this year.'
In such an environment, Argyle said he looks to add value by keeping the fund conservatively invested, and at present he has 9% of the portfolio in investment grade corporate bonds.
The historically high gilt issuance expected over the coming year is already largely reflected by the underperformance of longer-dated bonds, he added.
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