Gilts are worth considering

Gilts are now on the radar

Gilt edged investments are offering returns that are now worth considering.

Gilt edged yields are providing both short, medium and long term nominal returns that are greatly improved when compared to the recent past and to other government bond markets.

At present yields on 2 year gilts are over 5% and over 4.5% for 5 year gilts and there are similar yields for 10, 20 and 30 year gilts when held to maturity.

source: www.bloomberg.com

Just to illustrate the point, back in October 2021 the UK Treasury 1% 2024 gilt was offering a yield to maturity of just 0.54%.

Right now the same UK Treasury gilt is offering a yield of 5.32% if held to maturity.

source; www.worldgovernmentbonds.com

Current yields on 1 year gilts are substantially higher than at any time over the last 9 years.

These yields especially on short dated gilts are significantly more than bank and building society deposit rates. They offer an attractive alternative to cash or term deposits and as obligations of the UK government should be considered risk free from the point of view of interest and return of capital.

As government securities they carry a AA sovereign rating.

Gilt yields offer attractive nominal returns compared to the 13 year period of sub 1% interest rates post the 2008/2009 financial crisis.

The world has moved on from zero interest rates policies (ZIRP) and central banks all over the world have focused on defeating inflationary forces that many financial commentators say were a by-product of the low rate era.

Whilst income from gilts remain taxable at the taxpayers’ marginal rate, when held outside an ISA, any capital gains on gilts are tax free whether the gilt is held to redemption or sold prior. Both income and gains on gilts are tax free inside an ISA.

So why are gilts offering higher yields?

Well, so they should. Inflation is quite high and has become embedded in the service sector and in consumer’s inflation and pay expectations. This is contrary to earlier forecasts that inflation would be ‘transitory’.

In the 1970’s a series of inflationary policies, coupled with economic shocks at the start of the decade, unleashed considerable inflationary forces that took over a decade to quell.

Numerous parallels can be drawn with the 2020’s, inflationary policies, near zero interest rates, ‘money printing’ were in place prior to the inflationary shocks of the C-19 pandemic and Russian invasion of Ukraine on the 24^th February 2022.

The Bank of England embarked on the rate hike cycle in December 2021 – a full 18 months ago, the Bank Rate had been lowered to 0.1% during the C-19 pandemic. But when UK consumer price inflation (CPI) hit 5.4% a rise of 0.3% from November 2021, the Bank’s Monetary Policy Committee decided to start applying the financial brakes.

Higher interest rates when used against inflation is a blunt and generalised tool that takes time to feed through. It is similar to prescribing a patient medication, its effectiveness may depend on the dosage and the length of time it is being taken. There are distinct first order and second order effects.

Higher interest rates work faster to reduce loan and mortgage demand, and housing demand, as a first order effect.

But if the interest rate rises are delivered slowly over a long period, it gives borrowers time to adjust and take precautions. Arguably the protracted 18 month ‘hiking cycle’ has given sufficient time for consumers and businesses to manage higher interest rates.  It seems the impact was accommodated and did not slow the economy sufficiently to cut inflation, the second order effect.

In the current hiking cycle UK CPI has risen to 8.7% by June 2023 a full 3.3% higher than the 5.4% rate, when interest rates started rising in December 2021.

There are numerous explanations put forward for the UK’s lack of progress in fighting inflation:-

1. Unlike previous inflationary periods, nowadays it takes longer for higher financial costs to ‘feed though’ to the economy because most people (>85%) hold fixed rate mortgages and fixed rate personal loans. Until their ‘mortgage fix’ expires, the consumer gets the low ‘old’ rate. By the end of 2025 most of the mortgage fixes agreed before December 2021 will have expired. But that is 18 months away.
2. Retail ‘profiteering’ i.e. companies have instigated price rises whose aim is to boost profit margins, and exceed cost increases.
3. ‘Brexit’, and a smaller UK workforce post the pandemic and low unemployment has led to higher pay rises because companies prefer to retain staff rather than incur the cost of redundancy and then the cost of hiring and training new employees.
4. Residual pandemic/ ‘furlough’ cash has provided a cushion against higher costs. Evidence suggests the experience of the C-19 pandemic has led to consumers holding more cash than previously.

These factors, and others, have numbed the impact of higher interest rates on inflation.

The current inflationary mentality is that it is ok to pay higher prices because income is expected to rise sufficiently to compensate.

Gilt yields have therefore increased, they need to compensate investors for higher inflation and expectations of more persistent inflation.

A more ‘muscular’ approach has now arrived

However on the 22nd June 2023 the Bank of England signalled a tougher approach to UK monetary policy. There was a noticeable hardening of the tone of its language about UK inflationary pressures. The Bank of England lifted rates by 0.5% to 5%, 0.25% more than market expectations, and suggested further rate increases would be necessary. In the minutes of the meeting explaining the decision the Monetary Policy Committee said:-

1. “Higher inflation, especially services inflation, meant it had to act faster to bring prices under control”
2. “We cannot continue to have the current level of wage increases”
3. “There has been significant upside news in recent data that indicated more persistence in the inflation process against the background of a tight labour market and resilience in demand”.

The Bank has realised that on the current trajectory, it was unlikely to meet its 2% inflation objective by December 2025. Inflationary pressures have been too durable. Furthermore, the monetary medicine delivered so far had been insufficient and the time frame was more pressing.

Since the rate hike, investors have applauded the Bank’s tougher stance. There has been a jump in medium and long dated gilt prices, the area of the gilt market that is more inflation sensitive. This suggests that investors believe inflation will decline faster if Bank takes a tougher approach now.

The expectation now is interest rates may have to rise to 5.75% or even 6% in 2023 for the UK economy to slow sufficiently for inflation to start consistently falling.

It brings to mind what was said in the inflationary spiral of the late 1980’s which was only stopped by 15% base rates in 1990.

“It did hurt. I said it would. I told people in 1989 – “if it isn’t hurting, it isn’t working.” But now it is working.” Former PM John Major speech to Conservative Central Council 1 April 1995

A tough monetary policy will work, if set at the right level, if it hurts.

However other factors may well help over 2023 and 2024 in delivering inflation declines.

1. A slowdown in global GDP growth
   According to Schroders Economics global growth will slow from 2.4% in 2023 to 1.9% in 2024 due to a possible US recession in late 2023. The US Federal Reserve under Jerome Powell is determined to return inflation back to 2% and has made good progress in cutting US inflation.The protracted Chinese recovery and stalling growth in emerging markets that have been impacted by higher US dollar/ global interest rates will also dampen global GDP.
2. Political uncertainty
   The next General Election must to be held by 28^th January 2025 and our view is the present government will not want to call an early election. This is likely to be a very close and significant election. Election uncertainty could well dampen UK economic activity as consumers and businesses put off making major decisions until the election result.
3. Consumer squeeze
   By end 2024 c. 4.4m more people will have come off fixed rate mortgages. Using an average mortgage of £200k over 25 years this will take between £388-£440 out of monthly budgets and considerable demand out of the economy.

Conclusion

Gilts yields offer high returns relative to bank deposit alternatives and are attractive short term investments that could appreciate from current levels if inflation subsides quickly. Of course inflation levels could remain high, and interest rates are likely to rise further. It could take until end 2023 to be sure that interest rates are at levels that dampen inflationary pressures.

The 2020s has so far been a tumultuous few years and gilts at current prices offer a low stress alternative to other asset classes. Gilts main attraction as a means of portfolio diversification is important in such uncertain times. Furthermore the current harsh treatment of short dated gilts relative to other government bonds is unlikely to last.

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