Friday, 24 April 2009

Reassessing Gilts: don't panic Mr Mainwaring!

In light of the 30-35 basis point back-up in the 10 year Gilt yield, pushing it above 3.5%, it is time to reassess the investment case for Gilts.

A tumultuous week for Gilts started with Alastair Darling's pre-budget speech, in which he announced the Government will borrow £220 billion this fiscal year, increasing the public debt:GDP ratio from 45% to 76.2% by 2013. This was followed by a Moody's report, How safe are safe havens?, which sent yields higher and Sterling lower, on concerns over the UK's credit rating. Finally, Q1 UK GDP came in worse than expected at -4.1% year-on-year, the worst since 1979.

So, which, if any, of these facts warrant higher Gilts yields?

Increased Gilt issuance
Economic s 1.01 says that, increased supply of a good results in a lower price unless there is a similar rise in demand. However, as the chart below demonstrates, there is little or no relationship between Gilt issuance and Gilt returns. Indeed, the 2008/ 09 financial year saw record gross Gilt issuance of £146.4 billion and the third highest Gilt 12 month total return of 6.8%.

Further proof that bond issuance and returns are not related comes from Japan, where a sustained increase in public debt has been accompanied with a fall in JGB yields.

Moreover, the supply-demand dynamic has shifted in favour of Gilts due the Bank of England's QE programme. The full £100 billion authorised by HMT for Gilt purchases represents 18% of the overall £543.9 billion Gilt market and 45% of the gross issuance this financial year.

These percentages are not small. Indeed, at the end of Q1 2009, the Bank of England had 'only' spent £12.9 billion on Gilts, out of a possible £75 billion. Mervyn King has plenty of firepower left at his disposal with which to mop up new issuance and force yields lower. Thus, to some extent, what the Chancellor giveth, the Bank of England taketh away.

Moody's report
Next, the Moody's report. For all the hysteria it generated, the essence of the report was not as bearish as the market reaction. The conclusion is summarised below:

"Moody's believes that Aaa governments' unconventional policies are defensive responses that are – at best – ratings-neutral if they succeed in kick-starting economic activity. However, if they lead to massive increases in public net debt and a permanent deterioration of debt affordability without tangible growth effects, Moody's cautions that they will be ratings-negative. In extremis, since confidence is not a linear process, these policies could potentially increase 'tail risk', and therefore also the (currently small) risk of sharp rating migration."

Indeed, a spokesman for Moody's confirmed, "the [UK] rating has not changed, and it's not under review for a downgrade. The outlook is stable."

GDP and Gilt returns have a negative correlation, meaning that as GDP falls Gilt returns increase. The chart below demonstrates this by comparing year on year GDP against the 12 month total returns of Gilts.

So, why then was worse than expected GDP cited as a negative for Gilts? The answer could lie in the relative position of the UK versus other developed nations. IMF forecasts for developed nations' GDP are as follows:

The economic outlook for the UK may not be good, but it is no worse than in others countries, indeed, with the exception of the US, it is the best of a bad bunch.

Therefore, it appears that, on balance, nothing has changed the medium term term outlook for Gilts. Yes, inflation is a risk for the longer term, but as the above evidence suggests, none of the developments last week appear to warrant higher Gilt yields.

So, in the immortal words of Corporal Jones, "don't panic Mr Mainwaring!".

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