Investors in UK gilts face a range of different challenges as markets react to changes in inflation, interest rate outlooks and risk appetites. But the recent Budget may have offered a modicum of comfort, as yields fell in the immediate aftermath of the announcement.
Yields falling mean the price of the gilt is rising.
Investors in government bonds are not typically worried about the prospect of a default, rather it is the potential for an inflation shock to dent the real value of the returns from the bonds.
The potential for much higher inflation to negatively impact asset prices and economies is known as an inflation shock.
Gilles Moëc, chief economist at Axa, says fixed income markets responded well to the Budget, with the large amount of fiscal headroom and the fact the tax raising measures will not be inflationary, which provides some comfort to markets.
Number crunching
Moëc says many international investors have been buying gilts recently, which is coming, in his view, at the expense of the same investors purchasing other UK assets or investing in the wider economy. He says his could be harmful to the UK’s future growth prospects, but also that such investing can be “fickle” in nature.
Bond investors often allocate to government bonds in anticipation of a growth shock — that is, that growth will fall rapidly and investors will seek the safe haven of an asset that surely pays out an income.
Huw Davies, a fixed income fund manager at Jupiter Asset Management, says markets are currently expecting UK inflation to fall to about 2.5 per cent; at that level a 10-year gilt would be paying an income of about 1.8 per cent above inflation, which he says is attractive for income investors content to hold the asset to maturity.
For investors with more of a growth focus, Davies says the market’s view is that while UK inflation will fall, it will happen as a result of declining economic growth — that is, demand-side deflation, rather than deflation caused by an improvement in the supply-side conditions of the economy.
He says such a scenario would enable the Bank of England to cut interest rates, which would potentially boost the price of government bonds.
Aaron Rock, head of rates at Aberdeen, says the very low levels of volatility in gilt markets in the decade preceding the pandemic was abnormal and the result of quantitative easing, but may have created a situation where investors thought that was the typical, and were greeted by what he believes was the exceptional volatility of the post-Covid era.