You may have noticed recent turbulence in the global bond market, with the so-called bond vigilantes circling. Yields on longer-dated government securities across the G7 are rising and prices are falling, with most attention focused on the 10 to 30-year range.
This matters to mainstream private investors not only because of the effect on interest rates and government spending, but also because there is a concern that if longer-dated bond yields breach 6pc in the US, investors might switch from equities to bonds as yields look appetising again. This could trigger a US stock market sell-off.
In the UK, tax advantages are making gilts, including inflation-linked bonds, more appealing again. Last week, the 30-year gilt yield hit 6.04pc and the 10-year yield hit 5.5pc, the highest levels since 1998 and 2007 respectively, before easing on Friday as oil fell.
What’s driving this surge in yields is contested. Some argue that demand for borrowing from AI companies and a booming US economy are driving strong demand for debt capital, so yields might stay elevated for some time.
Another explanation is that surging energy prices, driven by the crisis in the Gulf, are pushing up interest-rate expectations. Markets are currently pricing in a percentage point of rate rises here in the UK over the next year, though that could turn sharply if the geopolitical environment quietens (a big if).
A third school of thought blames out-of-control government deficits. Bond vigilantes worry that Treasuries and central banks around the world will monetise deficits by trying to dampen bond yields, and maybe even administering another dose of quantitative easing (QE) during the next slowdown. If you buy this argument, you are probably worried about persistently above-target inflation, perhaps up to 5pc in the next few years, as countries print money in an effort to dig themselves out of a hole.
Frankly, how much weight you give each explanation depends on your point of view. My view is that expectations of interest rate increases are overcooked and inflation will fall, perhaps sharply. But I also concede that the long-term fiscal deficit challenge in the US and the UK is becoming worse, which means that the fiscal zeitgeist has changed. Bond investors now want greater long-term reward for greater risk, post-QE.
There’s a crucial point that is lost in the debate about bonds: for many private investors who are happy to buy a gilt and hold to maturity, what really matters is the yield you receive now and the total return during the lifetime of the investment.
Crucially, remember that capital gains on gilts are free of tax, although you do pay income tax on the interest unless you hold in a tax wrapper, which lots of investors do.
Let me explain, with a few examples, what makes some gilts seem more alluring to tax-sensitive UK private investors.
Take the Oct 2, 2029 gilt, which has a 0.875pc coupon. The last time I checked, it was priced at £89.14, and the actual running yield you would receive is just under 1pc a year using data from Killik & Co. But the redemption price in October 2029 gives you a total yield to maturity of 4.75pc.
For a 45pc additional-rate taxpayer, that’s a net after-tax total annual return of 4.33pc. For a basic-rate taxpayer, it’s even better at 4.57pc. Remember, capital gains are tax-free and you could always choose to hold the gilt in a tax-free wrapper like an Isa.
Alternatively, if you go right out to the long end of the maturity curve and buy, say, a December 2055 gilt with a coupon of 4.25pc, priced at £77.42, the annual gross return (including the yield and capital gain) is 5.88pc a year. If you are an additional-rate taxpayer, the net redemption yield is 3.59pc, while for a basic-rate taxpayer it is 4.86pc.
That yield could appeal to a near-retirement investor seeking a sustainable, annualised return free of default risk over the next few decades. By comparison, you could buy a single-life, level annuity at 65 and receive £8,172 in income on £100,000, according to Hargreaves Lansdown, but all that income is taxable, and you don’t recover your capital back at the end.
Index linkers are even more complicated, as they include both a capital uplift for inflation protection and a coupon paid regularly and increased by inflation. The average five-year index linker pays a profit of 1.1pc above inflation. For the 20-year, the real yield is 2.6pc.
Specialists in index linkers such as Chris Clothier, at CG Asset Management, say current real yields look very attractive in both the UK and the US. Clothier and his colleagues favour shorter-duration linkers with a bias towards US Treasury linkers, which are called Tips. That said, Tips are very tax inefficient to hold directly in the UK, according to Clothier. That is where their CG Dollar Fund comes in handy, as it holds Tips and has outperformed its benchmark since inception and by 1.9pc over the past year.
Mateusz Malek, the head of bond research at wealth firm Killik & Co, says his firm currently favours shorter maturity gilts, which offer lower duration risk and may provide better risk-adjusted returns in an uncertain environment. Malek warns that longer-dated gilts may face additional headwinds from the UK’s fiscal outlook, a view that Clothier shares.
Craig Inches, at Royal London, suggests that short-dated index-linked gilts provide a relatively direct way of protecting against that risk without locking money away for decades. “That said, we think the more interesting opportunity today may actually be in conventional government bonds,” he says.
“Yields are much higher than they were a few years ago, meaning investors can earn a healthy level of income, while inflation expectations already look quite elevated in many parts of the market.”
He also warns that long-dated index-linked gilts can be highly volatile because investors are trying to make predictions about inflation, interest rates and government finances many years into the future.
Some bond fund managers are even more cautious. Ian Williams, a former bond trader who now runs an active bond portfolio at Charteris Treasury Portfolio Managers, argues that UK gilts and other government bonds trade inversely to commodity prices, especially oil.
If the war with Iran escalates and oil prices rise, he argues the 30-year gilt yields could head towards 8pc, implying a possible bonds crisis.
According to Williams: “Everyone is asking the same question, ‘At 6pc yields should I buy some?’ No one ever asks, ‘I own this junk and am losing money. Should I sell to avoid losing any more?’ Our Gilt Fund has been in one to three-year gilts all year and we see nothing to persuade us to switch to longer.”
Leave a comment