managers expect returns on government stock of 3%PA maximum over the next few years compared with the 8%PA gains of the past
The gilt sector may have been the place to invest over the past three years, but few hold out hopes for superior returns relative to equities in the years ahead.
Graeme Caughey, manager of the SW Gilt fund for the past two years, expects gilts will deliver total returns of 2%-3% per annum over the next few years, compared to the 6%-8% rate enjoyed since the start of 2000.
The 25 funds in the UK Gilt sector returned an average of 17.9% over the three years to the end of July. By comparison, the global growth sector made negative returns of 38.64% while the UK All Companies sector lost 27.19%, bid to bid, according to Standard & Poor's.
Three funds in the gilt sector made returns in excess of 21% over the period. These included Royal London Fixed Interest (21.84%), SocGen Institutional Sterling Bond (21.81%) and Schroder Gilt & Fixed Interest (21.79%).
To qualify for the gilt sector under IMA rules, funds must have at least 90% of their assets in UK Government securities. Andrew Argyle, manager of the Schroder Gilt & Fixed Interest fund, said although he can hold 10% of the portfolio in corporate bonds down to a credit rating of BBB, this is not key in his portfolio management.
'We have about 6% of the fund currently invested in corporate bonds, and have held up to 10% in this asset class in the past. Generally speaking we do not aim to derive a considerable amount of value from this investment decision,' he said.
The Schroder fund tends to hold around 10 different gilts. However there is now a further 15 holdings through corporate bonds. Argyle explains that although corporate bonds represent a very small portion of the overall portfolio, it is important to diversify risk considerably.
He said that Schroders will look at any gilt in the market and is not restricted by duration.
'It depends on the investment view at the time. If I believe shorter-dated gilts are overvalued at any particular time, then I will opt for more longer-dated issues and vice versa. At the moment we are in the middle of this range,' he said.
Argyle's overall stance is neutral while looking to start buying some longer-dated securities. However, he expects they may become cheaper in the near term and so is holding off from increasing exposure.
'Since the middle of June there has been a bear trend that might just have a bit further to run in the short term,' he said. 'On the basis of where short-term interest rates are now positioned, and our expectations of further cuts, then I expect that on a valuation basis gilts look fairly good value at the moment. That is not to say in the short term that they won't become a little cheaper,' he said.
One of the problems hanging over the gilt market is the anticipated increased issuance by the Government. Argyle said although the market expects a certain level of increased issuance, this could be even more excessive than anticipated. Certainly, this would have a negative impact on the market, particularly in the longer-dated issues as added supply tends to cause the longer dated issues to underperform.
The Schroders fund posted slightly lower than average volatility, with annualised standard deviation of 4.48% compared to a sector average of 4.74%.
'The traditional way of managing bond funds has been by duration. This involves guessing which way the market is going to go and positioning the fund accordingly,' Argyle said.
'We do incorporate these positions into our portfolio but we do not rely on them as a key way of adding value. We do tend to look at the relative value of individual gilts compared to the market.
'They tend to be small relative value movements, but if you are able to move in and out a number of times per year, you can add a reasonable amount of value without taking any significant risks, as all trades are done on a duration-neutral value basis.'
Accordingly, Argyle said he is always trying to build a portfolio of the cheapest gilts. When they become more expensive he will take profits and move into cheaper issues.
'So it just about rotating the stocks we have to extract a small amount of relative value. It does add returns without taking a great deal of risk,' he said.
The Scottish Widows Gilt fund also outperformed the sector average, with returns of 19.1%. Caughey, the manager, said his portfolio holds 100% gilts, and from time to time has held some index-linked gilts.
After holding a defensive position for most of this year, Caughey has moved to a neutral position in terms of duration.
There are up to 12 gilts held in the portfolio, with maturities as early as this year to those that mature in 2036. In managing the portfolio he looks for opportunities to make capital gains as well as delivering a yield.
'If our objective first and foremost was yield, then we'd be looking for corporate bonds or overseas government bonds, which pay a higher dividend. But with yield there is no free lunch. Higher yield means higher risk. We are focused more on a total return than income yield. Thus we are looking for trading opportunities,' he said.
The gilt team at Swip has average turnover of 300%-400%pa, he said.
On the outlook for gilt yields, Caughey is conservative. He expects that 10-year yields will rise by another 10-20 basis points over the next 12 months.
'This equates to a total positive return from gilts of 2%-3% over the next six months. This is much weaker than the last three years, where the figures have been closer to 7%-9%. The scenario is changing. The past three years have seen gilt yields coming lower, driven by central banks cutting base rates,' he said.
'We don't expect any further cuts from the MPC in future, but we also don't anticipate any rate increases. Interest rates are likely to be kept on hold until an economic recovery is firmly established.'
Meera Patel, adviser at Hargreaves Lansdown, said: 'We would not want to touch gilts at the moment. The yields are so low and the price is likely to come down with further issuance coming onto the market.'
Two global vehicles
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Will report to Mark Till