Gilts – reality starts to bite

Gilts – reality starts to bite

4 Feb 2013

“The UK is a must to avoid. Its Gilts are resting on a bed of nitroglycerine.” So said Bill Gross in January 2010. Mr Gross (who works for Pimco) is the best known bond investor in the world. He is the only fixed interest specialist invited on to the Barron’s Roundtable. When he made that comment, 10 year Gilts yielded 4%. Eighteen months later their yield had fallen to 1.5%. As it turned out, Bill Gross was warning people away from a gilt-edged buying opportunity.

To be fair, the stellar performance of gilts, as well as US Treasuries and German Bunds, required the normal rules of value to be suspended. The era of very low bank rates, negative in some cases in nominal as well as real (inflation adjusted) terms, accompanied by quantitative easing (the process by which central banks purchase long-term assets for cash)has resulted in investors and savers becoming increasingly desperate for yield. People who are desperate for yield will gradually accept both lower returns and higher risks.

By any sensible standards, the UK state is rather high risk. While it is true that a sovereign government with its own currency will never actually go completely bankrupt (because, in popular terminology, it can print its own money – an option no longer open to e.g. Greece), uncontrolled borrowing will lead straight to devaluation and inflation. The main worry about investing in the UK is not default: it is getting stuck with an asset whose price falls painfully, leaving the choice of selling at a loss or continuing to hold paper that yields well below the prevailing levels of interest rates and, most damagingly, inflation.

The history of the UK economy can be seen in the nominal yield of gilts and the price movements. The first gilt I ever bought was issued in April 1992. It had a nominal yield of 8.75% and a life of 25 years i.e. it will redeem at par (100) in 2017. It is hard now to imagine that the government would offer investors a guaranteed 8.75% for 25 years: that is because the equivalent offering today (there actually is a 4.75% 2038 gilt out there) yields 3.2%.

The Debt Management Office has to pay the interest rates of the time when it is required to raise money for the Treasury. Last year it managed to issue a 10 year gilt with a nominal yield of 1.75%. Who will own up to having bought that, I wonder? It now yields 2.15% meaning, obviously, that they are showing a loss. That particular issue may one day be seen as the bubble moment in the gilt market, just as the early 1980s, when some long-dated gilts were issued with double-digit coupons, is seen as the most enviable buying opportunity.

The yields offered by building societies and banks have finally sunk towards the unattractive depths offered by the government. This tells us that our financial institutions are less than eager for our money and that we, in our desperation for yield, are running out of ideas. Savers are less worried about the solvency of banks, not least because they are fairly sure that the state will prop them up, if necessary. Unfortunately they have more cause to be fearful about the financial health of the state itself.

Political debate in the UK now centres on the question of whether the austerity policies of the coalition are too severe. My dictionary defines “austere” as “rigorously self-disciplined and severely moral; ascetic; abstinent”. You can see why politicians might be sceptical that people will vote for that. Yet, it is widely recognised that gilt investors might go on strike if the government dropped “austerity”.

Yet when one looks at the numbers, austerity is extremely hard to see. In order for anything to be given up, it must have been adopted in the first place. The best that can be hoped for is annual deficit reduction i.e. that the total of outstanding national debt rises more slowly but not that it actually falls.

The recent political debate about housing benefit illustrates where we are in reality and in public perception. The coalition government is capping increases in housing benefit to 1%. Given RPI of c.3%, this is a real cut. Cue much political noise and claims that it should be the rich and not the poor who suffer (the rich rarely receive housing benefit, I imagine, though, given the numbers that follow, I would not completely rule out the possibility). Clearly, if you are a net contributor to, rather than recipient of, housing benefit, it is relatively to your advantage if its rise is checked.

Sadly for those who are net contributors to the national finances, the word that one would pick for housing benefit costs is not “checked” but “rampant”.

In the four years from Q4 2008 to Q4 2012, the number of people receiving housing benefit has risen by 21%, from 4.2 million to 5.1 million. Adding those who receive council tax relief, the number rises to 6.5 million. Unsurprisingly, almost all the increase is from people under the age of 65 (+30%): the number of people over 65 receiving housing benefit rose by just 1.6% in aggregate over the four years.

The average annualised payment rose over the time rose by 16.5% to £4650. Factoring in the rise in recipients, the rise of individual pay-outs and the growing representation in the mix of the under-65s (who cost more) and the net result is that the total cost of housing benefit has risen by 41% over the four years. That is one rampant number for a recession and a time of austerity.

It doesn’t matter where you stand politically. This is a big number and there is no practical chance of it going away until some prosperity returns and real incomes grow (though a fall in house prices and rents would help); and housing benefit is just an example of a general problem. Almost all government spending climbs inexorably. According to long term budgets, pension expenditure will be the biggest riser. Welfare is supposed to fall, as it education (see my post about UK student loans). Without economic growth, the debt will continue to grow at an alarming rate.

Where does this prospect leave investors being invited to help finance the UK through gilt purchases? The brief answer should be “sitting on their hands until they are offered more favourable yields”.

In general, people do not anticipate the timing of significant market movements. It seems as the bank rate has been at 0.5% for ever and last year long term gilt yields fell to levels (all-time record lows) that almost no one expected. These yields are consistent with an economic slump that lasts a generation.

An example often cited is Japan where government finances have been buried under the weight of debt for twenty years or so. Ten year Japanese government bonds yield a mere 0.75%. If Japan had to refinance itself at yields consistent with what appears to be its financial health it would presumably be forced to default. A number of hedge funds have tried to bet against Japan by (effectively) shorting its debt. This does not seem to have worked. Japan is a very insular country whose citizens are big savers. They seem to save by buying government bonds, effectively and patriotically propping up their country’s finances.

I doubt if this will happen in the UK. A huge number of UK assets are owned by foreigners. If they fear, as arguably is starting to happen, that sterling is at risk of devaluation, they will probably be inclined to dump liquid UK-centred assets such as gilts. Maybe Bill Gross was just out by three years.

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