Mark Parry extols the virtues of the gilt market
In these troubled times, what would investors' appetite be for a vehicle that provided a guaranteed income stream, a principal guarantee over the life of the product, a broad choice of life to match investors' preferred time horizons and an opportunity for capital gains independent of the stock market? What I have described are some of the characteristics of that particularly unfashionable instrument known as the gilt.
In the current environment of, at best, volatile and, at worst, capital-destroying equity markets, a renewed focus on lower-risk investments should hardly come as a surprise.
Lower risk should mean lower return, but just look at the performance over the last 12 months ' the gilt market has returned a positive performance of more than 6.6%, while the FTSE 100 has given a negative return of more than -12%.
Is this a pattern that is likely to continue? It is certainly our view that over time, everything else being equal, equities should outperform bonds. In the short to medium term however, the weakening economic picture provides a very bond-friendly backdrop. Central banks have been cutting interest rates in response to declining output, but the expected recovery has thus far failed to materialise. Low inflation and below-trend growth means there is scope for rates to fall further should the need arise. All in all, this is an environment in which bonds should do well.
Ignoring the tactical arguments for gilts, there are more strategic reasons for ownership other than as a diversifying asset. Those approaching retirement whose pension investments are literally mature will need to consider their conversion risk.
The debate about the forced buying of annuities will doubtless continue but for now, annuity rates are the main determinant of returns from defined-contribution schemes. In turn, annuity rates are a function of longer-dated gilt yields. A progressive shift from riskier assets into gilts is one way of minimising this conversion risk.
The provision of retirement income is one of the broader issues arising from the current annuity debate. Is it a huge conceptual leap to move from producing an income stream derived from long-dated bond yields and unbundle the product to invest individuals' accumulated capital more directly in the gilt market? The obvious advantage would be the relative control of the principal, notwithstanding any volatility of capital in the intervening period.
One presumes retirees would require some form of 'wrapping' and tailoring of the income stream, but could this prove a relatively simple solution to some of the more complicated alternatives that are currently only available to a few? Again, this is another potential demand-led support for gilts.
A related issue to the individual investors' demand for gilts is that of the pension funds.
Boots became the first major UK company to adopt FRS17, the accounting principal that requires pension fund liabilities to be discounted at a long-dated bond yield. The Myners Report also calls for the abolition of the Minimum Funding Requirement and a longer-term approach to investment. The accounting regime suggests a renewed emphasis on matching liabilities. The outcome is continued, and probably increased, demand for longer-dated bonds.
Despite the longer-term potential of equities to outperform, their greater volatility could be particularly damaging within the finite time horizon of a mature investor. The increase in volatility in an environment of declining nominal returns means the potential, longer-term gain could be more than wiped out in a few trading sessions. A long-term return of 9% per annum sounds great but what if the market falls by 9% in nine trading days as the Nasdaq did earlier this year?
In a low inflation environment, while the absolute return of gilts may seem unattractive, the real return is still positive and not insignificant. The case for gilts is even stronger if, given the lack of 'flattering' inflation going forward, perhaps we have seen the best of the high, nominal equity returns. What price a truly guaranteed income?
Much has been made of corporate bonds as a suitable income vehicle for those looking to increase their income in a time of low cash rates. While we would not wish to decry the asset class, it is important to realise that the reason corporate bonds provide a higher yield than government bonds is that they are, by definition, more risky because of the greater chance of default. And in the current economic environment, everything else being equal, that risk is likely to rise.
By all means invest in corporates, but remember that they are not a true deposit substitute but rather a hybrid instrument showing characteristics of gilts and equities.
Supply and demand
Another factor affecting the price of gilts has been their relative scarcity. It is now accepted economic orthodoxy, at least in the major Western countries, that a prudent approach to government finances is appropriate.
The debate in the US has focused on how best to use the budget surplus, not whether there will be one. Notwithstanding any politically expedient calculations pre-EMU, the eurozone is at least theoretically bound by a budget deficit limit of 3%. Closer to home, the 'Iron' Chancellor has made much of his repayment of debt. While part of this, both at home and abroad, has been a function of strong growth, the secular trend is very much intact. Any economic weakness means a delay in reducing the stock of government debt rather than a reversal of the trend. So the shrinking volume of gilts should continue to be a supportive factor going forward.
At the same time, the stock of non-government debt is increasing. Corporate bond issuance has soared this year as weak equity markets have forced companies to seek alternative routes to access capital markets. At the same time, investors have sought solace in less risky assets than equities, creating a virtuous circle of supply and demand.
As well as the absolute amount, the relative proportion of gilts in the UK bond market has also declined. Just comparing gilts to the highest quality sovereign and supranational bonds, the change has been marked even over the last year.
On both a relative and absolute basis, the scarcity of gilts has increased. This is a price-supportive trend that is set to continue.
So are gilts the investment equivalent of a free lunch? Well, unsurprisingly, they are not without risk and the value of most securities can down as well as up. Gilts have mark-to-market risk like virtually all investments.
There is no guarantee of the market price on any given day but, providing you choose carefully, you can get your original investment back, having received an income flow and taken no credit risk beyond that of the Government.
None of this precludes the opportunity of capital gain. Assuming you can take a defined investment horizon, you can lock in a guaranteed investment return with absolute certainty of income and principal. All of this is in marked contrast to more esoteric 'guaranteed' products that are dependent on the performance of a range of underlying assets.
The Oxford English Dictionary defines 'gilt-edged' as 'securities of exceptionally high value, also used to denote something of very high quality, richness, and elegance'. An elegant and high-quality investment anyone?
• In current environment of volatility, renewed focus on fixed income is hardly surprising.
• The reason corporate bonds provide a higher yield than gilts is because they are higher risk.
• Gilts have mark to market risk like almost any investment.
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From 6 April 2019
Marcus Brookes appointed CIO