Long-term gilts may lose their lustre

Apr 29 2009 by Andrew Miller, The Journal

ALISTAIR DARLING did something impressive last Wednesday: He managed to shock the bond market, even though it was well prepared for bad news.

The issues most troubling for gilts investors are:

Gilt issuance is forecast to be £220bn, significantly above the £180bn-£200bn figure mooted in the Press.

This is driven by the public sector deficit hitting 12% of GDP; furthermore, total Government debt will amount to 80% of GDP by 2014 and only start falling by 2017.

These forecasts are based on the assumption of a rapid rebound in growth in 2010; therefore, there is further downside risk.

The Government is struggling not only because the economy is contracting, but also because its tax receipts are shrinking faster than the economy, while expenditure remains stable or is rising (due to things like unemployment benefits). There is some chance that receipts may grow more rapidly than currently estimated, especially if inflation rises, but it currently appears that the bond market will be called on to absorb a lot more issuance than in previous years.

Investors have clearly taken fright, and while the Bank of England’s programme to buy gilts offers some support in the short term, it is only a temporary fix: when the Bank decides to exit this programme it, too, will become another major source of gilts for quite some time.

Unsurprisingly, gilts generally sold off following the Budget and there was also increased concern that the UK could lose its long-held AAA credit rating. Moody’s, the credit rating agency, understandably said that a persistent deficit above 5% could be a reason for reviewing the UK Government’s rating over time, but a change in the short to medium term seems unlikely, especially as Standard & Poor’s recently reaffirmed its AAA rating.

How does all this affect the outlook on gilts? Clearly, none of it is good news, but in the short term the negatives should at least be cancelled by the Bank of England buying gilts. It is also possible UK pension funds (which in theory have the potential to buy practically everything the UK Government could issue) could start buying more gilts; however, many may be reluctant to do so, given their current funding positions look pretty dire. Therefore, the supply position looks increasingly negative for gilts, especially once the Bank’s purchases end.

Of course, supply is only one factor to consider, but the other variables that we believe are important (ie business cycle data, inflation, risk appetite and momentum) are becoming less supportive as well. Although the macro picture still encourages one to favour gilts, it is slightly less bleak than it was a month ago, while the recovery in equity markets suggests investors are not as risk averse as they once were. Price momentum has also faded and is no longer an argument for favouring gilts.

Therefore, we are increasingly hesitant to recommend investors buy long-maturity ordinary gilts. While it seems likely that short-dated yields will stay low for an extended period (given the Bank of England is unlikely to raise interest rates any time soon) longer-dated bonds look increasingly vulnerable to supply indigestion, as well as any improvement in economic activity. Of course, a quicker and larger-than-expected rebound in the economy or inflation should be very helpful to the Chancellor, but these factors will be more negative for bond holders than any beneficial impact they may have on reducing supply.

Andrew Miller is regional head of Barclays Wealth