The UK Bond Bubble - A Time For VigilanceChristopher Peel - Chief Investment Officer
The bubble in the UK bond market is beginning to show signs of stress and when it eventually bursts, the losses suffered by the most risk averse investors are likely to be substantial and take years to recover. UK government and corporate bonds typically comprise more than half of the assets held in defensively managed portfolios. This will present a huge problem for many, especially those approaching or at retirement age.
Bond prices have become grossly inflated across the yield curve and offer little protection from either the rising levels of inflation, supply or credit default risk. The Bank of England has contributed to the price distortion by reducing short-term interest rates to the lowest level on record, increasing the size of its quantitative easing programme and propagating an overly pessimistic outlook for the post-Brexit economy. The data released in the UK since June indicates that the economy remains largely unaffected by the vote, and is nowhere near falling over the cliff predicted by the scaremongering “Remain” campaigners.
The International Monetary Fund recently confirmed that the UK will be the fastest growing major economy (G7) in 2016, and retracted its earlier prediction of a Brexit induced recession and stock market crash. It is clear that the journey out of the European Union will present challenges along the way, as evidenced by sterling’s “flash crash” earlier in the month. However, Theresa May has shown strong leadership since taking over as Prime Minister and is committed to negotiating an orderly exit plan that protects the long-term interests of the country.
The rally in the gilt market over the last decade has driven yields and corporate bond spreads to the lowest on record, and the risk-reward trade off for holding debt securities yielding less than one percent is extremely poor. The upside is limited and the downside is significant in light of the fact that real yields (yield-to-maturity less the inflation rate) are negative across much of the government curve. This will only get worse given that the annual inflation as measured by the Consumer Price Index has risen to 0.60%, and is set to climb further following the recent deprecation of sterling. To make matters even more problematic, the supply of gilts is going to rise with the government’s pledge to increase spending on productivity-enhancing infrastructure projects in the upcoming Autumn Statement.
The weighted average maturity of the UK gilt market (conventional) is 15.95 years and the weighted average yield to maturity is 0.82%. The effective duration of the market is 11.23 years, which means that for every one percent (100 bps) change in rates, the average price movement will be approximately 11.23%. Given the prevailing yields in the market, it is more likely that rates will increase, especially with the expected rise in inflation and gilt issuance. If the average yield to maturity in the market increases by 100 bps to 1.82%, not only will investors lose more than 10% of their capital, but it will also take more than five years to earn back their money given that yields will still be below 2%.
The timing of the inevitable sell-off is extremely difficult to predict. However, it’s clear that much of the bond friendly news that has fuelled this rally is now fully priced into the gilt market. It’s theoretically possible for inflation to fall, gilt issuance to decline and economic “Armageddon” to descend upon the UK, but this is not very likely.
Tavistock Wealth has recently reduced the duration of its bond portfolio and recommends investors review their allocations in the UK government bond market. Investors should look to replicate the same risk exposure by investing in short to medium duration UK corporate bonds, and in the GBP hedged share classes of global investment grade, global high yield and emerging market debt funds or ETFs.
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The following is an abbreviated version of John Leiper’s article ‘Tide may be about to turn’ for Investment Week magazine. Follow the link and read his views on page 23.
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