What a difference a year makes. Twelve months ago the threat of deep global recession seemed very re...
What a difference a year makes. Twelve months ago the threat of deep global recession seemed very real, but investors are now wondering what all the fuss was about.
This dramatic swing in both sentiment, and cyclical developments, explains the poor performance from bond investments, both in the UK and globally this year. Though off of their highs, five-year gilt yields are now almost two percentage points above their February levels.
Having said that, the gilt market is currently two markets in one. While shorter-dated gilts have risen dramatically in response to the underlying economics, the focus at longer maturities has been the persistent imbalance between supply and demand - the product of accelerating pension fund demand for gilts under the Minimum Funding Requirement (MFR), against the backdrop of shrinking supply.
The weight of numbers in this particular equation is so powerful that long-dated gilts continue to yield just 4.5% - barely off their lows of earlier this year. These yield levels, from a fundamental economic perspective, are simply wrong! Indeed, they imply that short rates will fall to around 3% in 15 years time and that 10-year gilt yields will fall to 3%-4% below equivalent German levels. The economic scenarios that would support such valuation levels are difficult to imagine - such as deflation in the UK while Euroland motors ahead.
This distortion could be corrected by any one of three developments. First, a change to the MFR regulations, which would encourage pension funds to explore opportunities in the non-gilt sterling bond market. Second, a change in the maturity profile of gilts (a focus on long-end issuance. Third, a more positive stance on Emu entry, which would reduce the longer-term risks of increased investment in Euro-government bonds.
Though the third of these would appear unlikely at present, we await the outcome of a review of the MFR, and 'switch-auctions' could alter the maturity profile of gilts. Thus, the event risk associated with investment in longer-dated gilts is extremely high. A correction of the current regulatory-driven distortion could entail an upward move in long yields in excess of one percentage point, though of course the timing of this is extremely uncertain.
We are, therefore, focused upon strategies, which would reduce exposure to such event risk. The best risk/reward relative to a neutral position in gilts, would probably come from investment in bonds issued by supranational bodies, such as the European Investment Bank. These are triple-A-rated, guaranteed by member governments, and reasonably liquid.
Furthermore, longer-dated such issues currently offer 0.8%-1% over equivalent-maturity gilts. To put this into perspective, such bonds were actually yielding less than gilts just three years ago. Therefore, such a strategy should benefit from a significant narrowing of this yield differential were long-dated gilts to come under pressure.
An alternative strategy would be to express a pure yield curve view - under-weighting expensive long-dated gilts, in favour of shorter-dated gilts. The latter currently yield in excess of 6%, reflecting a far more pessimistic view of the outlook for official rates than our own. We expect rates to peak at 5.75% to 6.0% in the early part of next year, while market yields imply a rising rate profile throughout next year, and beyond, with an ultimate peak above 7%.
But the cyclical risks, which have driven markets lower this year, cannot be ignored, and could keep short-dated gilt yields volatile. Thus, should it be some time before the event risk of regulatory change hits the long-dated sector of the market, near-term risk exposure could actually be increased significantly under such a strategy.
Mark Manning is senior portfolio manager at Dresdner RCM Global Investors
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