The UK has never defaulted on its debt. As John Pattulo of Henderson puts it: “The UK is AAA-rated, with a credible, independent central bank, that can print its own currency,” reducing the likelihood of bond investors losing money.
Helped by the Eurozone crisis, UK yields are at historic lows: the average yield on ten-year debt over the last 20 years was 5.23 per cent; today, it is around 1.70 per cent. Low rates and quantitative easing (QE) – which focused on buying government bonds – are the main drivers. The Bank was, until recently, the chief buyer, and now holds 26 per cent of all gilts issued.
Since the onset of the crisis, sterling has devalued by 20 per cent. “One way to get through a crisis is to have a currency that you can print and devalue,” says Pattulo, “making the UK more flexible”. Euro countries do not enjoy this flexibility.
“From a valuation perspective, gilts are expensive,” says Pattulo. The retail price index measure of inflation is 2.6 per cent. Investors are therefore receiving negative real yields, in effect paying the government to hold their money. And not only are gilts expensive, they are underperforming: the FTSE UK Gilts Total Returns Index has delivered 5 per cent in the last 12 months, compared to 9 per cent from the FTSE All-Share Total Return Index.
A marked improvement in the UK economy could trigger a rise in yields: “A sharp rise in inflation coupled with a rise in growth, hence the need for a rate rise” could lead to a spike in yields, says Pattulo. But this can only happen if the economy improves sufficiently.
Currently, central banks are unlikely to increase rates rapidly, and rates will remain low for some time, supporting a low-yield environment. David Curtin of BlackRock says that we’d need to see a repaired banking sector and household deleveraging before this happens. “This could be a long process, and we’re only about half-way through the adjustment.”
Positive news from the Eurozone has the potential to impact gilts. As the situation improves and money markets resume normality, money will move out of gilts putting upward pressure on yields.
There is also a possibility that markets will lose faith in the UK’s economic policy – as they did with Spain and Italy. But Pattulo believes that this could only happen if the Bank begins cancelling its holdings. Last week’s move to return interest earned on gilts back to the Treasury did not cause a violent reaction.
If yields were to rise sharply, the euro crisis has shown us a blueprint of how traders could position themselves: short bonds and banks; seek safety in US dollar, and potentially gold. But “protection of your capital becomes the priority,” warns Curtin.
Recent monetary policy has been designed to keep yields low, and there is speculation that more QE will come. Therefore, betting on a sharp correction is risky. If anything, yields will move up gradually, and only after the economy improves. That is the theory; but we have seen markets lose patience with theory before. It pays to be prepared.