Rerunning the Widow Maker
There have been a number of investment opportunities that have stood out over the last twenty years but few, at the time, seemed as compelling as shorting Japanese Government Bonds (JGBs) once yields slipped below 2% eighteen years ago. Fortunately I did not have the wherewithal to do much about this, so I escaped devastating losses as yields halved, halved and halved again. Anecdotally, this was a popular trade for the more sophisticated types in the hedge fund world. Eventually, the trade rather darkly earned the moniker 'the widow maker'. Following the financial crisis, JGB yields have continued to spiral lower until, almost with a resigned inevitably, the 10 year note finally sunk into negative territory in February. This article covers some thoughts as to whether gilts are investable for retail clients on current yields or whether buyers should be institutionalised (in either sense of the word).
In December, following a protracted wait, the US Federal Reserve lifted interest rates. This is 7 years after rates were slashed to near zero levels during the financial crisis. Since when the banking sector has been restored to health, the housing market revived and unemployment levels have halved. The Fed clearly intended to make this the first in a series of rate rises, but recent events in markets has really put the need for further tightening into question. Disinflationary pulses continue to reverberate across the global economy and evidence is mounting that there is too much capacity across swathes of industries. Whether the current episode is a continuation of the trend or marks a final spasm is unknown. What we do know is that many of the central banks that have lifted interest rates since 2009 have subsequently been obliged to reverse them. It is not inconceivable that the Fed is making a similar policy mistake.
As a stand alone proposition, gilts are eye wateringly expensive. Inverting a 1.5% yield gives a price to yield ratio of 66x. This is expensive, even for the raciest of growth shares which rarely trade on p/e ratios ahead of this. Yet the income growth potential from gilts is zilch. The ten year return of 15%, plus a trifle of compound interest, on offer from gilts seems to provide far more risk than return. Capital values could easily suffer double digit losses in the short term if yields were ever to spike. After all, why shouldn't gilts be trading on yields closer to 3% or 4% in an economy where inflation is targeted at 2% and growth rates are around 2%?
Despite these valuation misgivings, gilts can still be an important component of a balanced portfolio. Put simply, they perform a role inside a diversified portfolio that is difficult to replicate using other assets. Good portfolio construction is all about blending assets that complement one another. If one part of a portfolio is zigging, it is a good idea to be holding something else that is zagging. Portfolios are generally made up off assets that contain a number of risks. These include: equity, currency, liquidity, credit quality and interest rates. One of the problems with this is that during a crisis, correlations across a wide range of assets begin to rise and any diversification benefits diminish. One of the few asset types that rise in value during these troubling periods are government bonds.
This is a valuable feature of gilts and very few other assets provide this sort of support during sell offs in risk assets. Equity options are one, but these are expensive to buy. In contrast, you are still paid to hold gilts. With interest rates so low, there may be a temptation to move into corporate debt. While these instruments do provide a higher yield, credit spreads are liable to widen in a crisis so the diversification benefits are muted. For this reason, the portfolios we run at Square Mile retain some exposure to gilts.
However, there are market environments where holding gilts may not be a good idea. A big risk is if inflation begins to revive. Inflation is utterly lethal for any conventional fixed income securities and periods of rising inflation can also impact on equity ratings. This is well worth bearing in mind. But just at the moment disinflation and indeed deflation seems more of a risk. The economic outlook remains very confused and there is no guarantee that cash rates will rise. So while gilt yields are admittedly very low, they still have an important role to play in a diversified portfolio.
In December, following a protracted wait, the US Federal Reserve lifted interest rates. This is 7 years after rates were slashed to near zero levels during the financial crisis. Since when the banking sector has been restored to health, the housing market revived and unemployment levels have halved. The Fed clearly intended to make this the first in a series of rate rises, but recent events in markets has really put the need for further tightening into question. Disinflationary pulses continue to reverberate across the global economy and evidence is mounting that there is too much capacity across swathes of industries. Whether the current episode is a continuation of the trend or marks a final spasm is unknown. What we do know is that many of the central banks that have lifted interest rates since 2009 have subsequently been obliged to reverse them. It is not inconceivable that the Fed is making a similar policy mistake.
As a stand alone proposition, gilts are eye wateringly expensive. Inverting a 1.5% yield gives a price to yield ratio of 66x. This is expensive, even for the raciest of growth shares which rarely trade on p/e ratios ahead of this. Yet the income growth potential from gilts is zilch. The ten year return of 15%, plus a trifle of compound interest, on offer from gilts seems to provide far more risk than return. Capital values could easily suffer double digit losses in the short term if yields were ever to spike. After all, why shouldn't gilts be trading on yields closer to 3% or 4% in an economy where inflation is targeted at 2% and growth rates are around 2%?
Despite these valuation misgivings, gilts can still be an important component of a balanced portfolio. Put simply, they perform a role inside a diversified portfolio that is difficult to replicate using other assets. Good portfolio construction is all about blending assets that complement one another. If one part of a portfolio is zigging, it is a good idea to be holding something else that is zagging. Portfolios are generally made up off assets that contain a number of risks. These include: equity, currency, liquidity, credit quality and interest rates. One of the problems with this is that during a crisis, correlations across a wide range of assets begin to rise and any diversification benefits diminish. One of the few asset types that rise in value during these troubling periods are government bonds.
This is a valuable feature of gilts and very few other assets provide this sort of support during sell offs in risk assets. Equity options are one, but these are expensive to buy. In contrast, you are still paid to hold gilts. With interest rates so low, there may be a temptation to move into corporate debt. While these instruments do provide a higher yield, credit spreads are liable to widen in a crisis so the diversification benefits are muted. For this reason, the portfolios we run at Square Mile retain some exposure to gilts.
However, there are market environments where holding gilts may not be a good idea. A big risk is if inflation begins to revive. Inflation is utterly lethal for any conventional fixed income securities and periods of rising inflation can also impact on equity ratings. This is well worth bearing in mind. But just at the moment disinflation and indeed deflation seems more of a risk. The economic outlook remains very confused and there is no guarantee that cash rates will rise. So while gilt yields are admittedly very low, they still have an important role to play in a diversified portfolio.