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Accumulator: grizzly gilts bear good and bad news

Accumulator: grizzly gilts bear good and bad news

by Danielle Levy Oct 21, 2016 at 13:58

Investor jitters about the UK economy sparked a sharp sell-off in the government bond market this week, pushing gilt yields to their highest level since the referendum.

There is an inverse relationship between gilt prices and yields, which means that if prices fall it causes yields to rise. This is what happened earlier in the week, as investors sold gilts on concerns about rising inflation and the prospect of a ‘hard Brexit’. This would see the UK excluded from the European Union’s (EU) single market.

Our exclusive Accumulator stock market data table shows that gilts tumbled 0.3% during the week and 2.1% over the past month. UK corporate bonds experienced similar falls, although eurozone government debt came off harder, down 1.2% on the week.

On Monday, gilt yields breached 1.2%, a level that hasn’t been seen since the UK’s EU referendum in June. It represents more than double the low that was reached on 12 August.

Inflation is the enemy of bonds because when you buy a bond you lock into a fixed income and this can be eroded by high inflation. Unilever demanding that Tesco pass on price hikes to consumers, as a result of sterling weakness, highlighted that inflationary pressures have already started to rear their head.

Higher-than-forecast inflation data released on Tuesday added more fuel to the fire. Consumer price inflation rose to 1%, representing its highest level since late 2014. Having fallen from the highs reached on Monday, the inflation data caused yields to rise once again. By Friday, the 10-year gilt yield had settled at 1.06%.

So what can investors learn from this debacle?

Chris Bowie, manager of the TwentyFour Corporate Bond fund, suggests the sell-off is particularly worrying because government bond yields determine what is known as the ‘risk-free’ rate of return. Lending money to a government is considered ‘risk-free’ because defaults are so rare. The risk-free rate underpins the pricing for all risk assets, namely anything beyond government bonds.

With the Bank of England having resumed 'quantitative easing' - or bulk bond buying - in an attempt to bolster the economy and lower long-term interest rates, the prices of gilts and other bonds had become expensive and vulnerable to a fall. Their rise had in turn pushed up the price of other riskier assets, including shares.

‘Far from being only a long-term valuation issue, in the short term, and despite buying from the Bank of England, UK risk-free rates are showing they are anything but risk-free,’ Bowie noted.

Income attractions

Laith Khalaf, senior analyst at investment broker Hargreaves Lansdown, says the jump in gilt yields is understandable, given that inflationary pressures have reappeared and yields had reached such low levels. He also suggests that the prospect of a US interest rate rise also spooked the gilt market.

If gilt yields continue to rise it will mean sharp falls for anyone holding them or investing in them via funds. However, if that happens there will come a point when income-hungry investors will start to invest, said Khalaf.

‘Income-starved investors can only ignore rising yields for so long, before they get tempted in, which puts something of a floor under the bond market, particularly when pension funds are gobbling up all the gilts they can get.

‘Indeed, the back-up in yields may offer some glimmer of hope for companies with pension liabilities, whose deficits may now be spiralling back into control,’ he explained.

Rising gilt yields also spells a rare piece of good news for people preparing to retire. Annuity rates, which have suffered a long-term slump as a result of falling rates, have risen 3.4% in the space of four weeks. This means that a retiree buying an annuity today with their pension pot will generate a slightly higher income for the rest of their lives as a result. 

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Comments  (2)

  • Stephen B.: 

    It would be useful to have index-linked yields too, so you could see how much is a rise in inflation expectations.

    13:34 on 22 October 2016

  • Ladysaver: 

    Agree. Much coverage of bonds, but rarely coverage of index-linked bonds.

    22:51 on 22 October 2016

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