UK government bonds offered pretty paltry yields for the past five years going into 2022 – and arguably longer. But that’s changed dramatically in the past year, says Stuart Chilvers, fund manager of the Rathbone Ethical Bond fund.
While it was still possible, in the low-rate pre-2022 period, to generate a reasonable income by purchasing certain gilts with a higher coupon, you were effectively committing to capital losses to do so, as the yields to maturity (which consider both income and capital returns) on these bonds were small. At the lowest point, in March 2020, an investor buying a 30-year gilt would have received a yield to maturity of just 0.51%.
Meanwhile, because the bond has such a long time before maturity, it meant you would be taking on substantial duration risk (the sensitivity of a bond’s value to changes in yield).
Arguably, investors were taking on a lot of risk for not much return. This dynamic also meant the UK Treasury was able to issue extremely long-dated bonds with very low coupons – for instance, a 2061 bond issued in 2020 came with just a 0.5% coupon. A small coupon also increases a bond’s duration. And so came 2022, when the benchmark 30-year gilt yield started the year at 1.12% and ended the year at 3.95%. At the time of writing, this 2061 bond now trades at £36.10, having been issued at £96.87.
Clearly, this was an incredibly painful year for anyone holding gilts. But it does raise the question: are gilts now an interesting option for income-seeking investors?
To answer that question, it makes sense to first take a look back at 2022. As has been covered extensively in the past year, inflation proved anything but ‘transitory’, as the vast majority of investors (and central bankers) had expected. This led central banks to take aggressive action by hiking rates at a pace not seen in many years to try and quash inflation that was many times target. Accordingly, government bond yields moved sharply higher and hence the moves described above.
However, while inflation has likely peaked, it remains a significant way above target. Indeed, core CPI, which central bankers tend to be more focussed on, hit a new cycle high in Europe at 5.6% for February. Economic data, particularly in the last month, has generally remained stronger than expected, fuelling investor expectations that interest rates will have to rise higher than had previously been expected, and could have to remain at elevated levels for a longer period of time to return inflation towards target.
When we look back over history, big declines in long-dated gilt yields (and hence rises in their prices) are rare before we see the last rate hike, which given the above would suggest that it could make sense to wait a bit longer before looking towards gilts.
However, commentary from the Bank of England has recently been less hawkish than either the US Federal Reserve or the European Central Bank, in our opinion, suggesting it could be closer to its final rate hike (although this is extremely likely to be dependent on economic data in coming months).
In addition, investors are receiving a yield of over 3.5% in all UK government bonds at the time of writing, which goes some way to helping compensate for the risk that gilt yields move higher.
Even for investors worried that inflation is going to remain stubbornly high and that interest rates will need to be hiked more than currently priced into markets, short-dated gilts could provide an interesting option, with one-year gilts yielding over 3.8%.
After an extended period when investors couldn’t achieve a meaningful income yield from gilts without accepting significant capital losses, the increase in yields in 2022 means gilts are likely to be back on the radar of income investors – particularly if they are looking for safer income streams for fear of an impending recession.
Any views and opinions are those of the investment manager, and coverage of any assets held must be taken in context of the constitution of the funds and in no way reflect an investment recommendation. Past performance should not be seen as an indication of future performance. The value of investments may go down as well as up and you may not get back your original investment
