In this analysis, Dan James, Head of Asset Management at Charles Stanley, makes the case for medium and long dated gilts and concludes that while absolute yields in both gilts and treasuries look attractive, at the margin, gilts may have the edge.
In early July, the UK Government issued a two-year bond with a yield of 5.668%. it was the highest yield on any gilt since 2007[1]. Yields at these levels look superficially appealing, yet the UK appears to have a more entrenched inflation problem than many of its peers. Investors are tentatively moving back to gilts, having held underweight positions, but might US treasuries be a safer bet?
Gilts should be a natural choice for a UK investor looking for a defensive option. They take no currency risk and they have no capital gains tax liability. However, gilts proved a dismal option in 2022, with gilt portfolios seeing double digit losses as interest rates rose. They also provided little protection against volatile equity markets.
Until recently, the gilt market still appeared to offer little value. Even after yields rose in 2022, the market did not reflect the increasingly different profile of UK inflation. Yields implied that the Bank of England would follow the path of other major central banks, with inflation edging lower.
Investors recognised that this was a false assumption, and continue to look elsewhere, often to US treasuries. Yields were higher, and investors could expect some uplift from the Dollar, which continued to show momentum in an uncertain climate.
Rising gilt yields
However, today, gilt yields offer a more realistic appraisal of the likely outcome on inflation for the UK economy. There is now a significant spread opening up over treasuries. At 4.4%[2], the yield on a 10-year UK gilt is at a significant premium to the US 10-year treasury, which sits at 3.8%[3]. A two-year gilt sits at 5.2%[4], versus 4.7% for the US equivalent[5].
The question is whether that spread is sufficient to compensate investors for the higher inflationary risks in the UK. There is notable gap between inflation in the US and UK. The latest CPI data from the US showed prices rising at 3%[6], down from 9.1% in June 2022. Core inflation was 4.8% and showed the smallest monthly increase since 2021.
Other US data supports this more benign outlook on inflation, particularly consumer credit. The more recent figures were much lower than expected, showing consumer credit rising $7.2bn versus an initial estimate of $20.3bn[7]. This was the smallest monthly gain since 2020 and shows the US consumer is starting to slow. This should be good for inflation and is another reason for the Federal Reserve to stay paused on interest rates.
UK inflation
In the UK, CPI inflation remained high at 7.9% in June [8], with rising prices for services a particular problem area. Core inflation sits at 6.9%. The Bank of England is still forecasting falls for inflation in the coming months, but with certainty than before.
Investors have to make a trade-off between higher yields and inflation risks. Increasingly, however, many believe they are sufficiently compensated by gilt yields. The latest Investment Association statistics show that UK gilts were the third best-selling retail fund sector, with net inflows of £344m over May[9].
We agree that gilts do offer greater compensation for the risks investors are taking on UK inflation and rate rises. However, investors need to be selective. At the short end of the maturity curve, there is a pick-up in yield of around 0.5%. While absolute yields are high, this is not as attractive because UK base rates may top out slightly higher than US rates.
Medium and longer-dated gilts look better value. They provide a meaningful uplift over treasuries and yet the differential in interest rates and inflation outlook is unlikely to endure over the longer-term. Two-year bonds tend to be determined by the prevailing cash rate set by central banks, while the 10-year bond reflects expectations for future cash rates based on expected inflation. It is here where there appears to be a greater gap between expectation and likely outcomes.
Currency considerations
Holding Dollar assets over the past decade has been beneficial, and during the pandemic period in particular. The Dollar has fulfilled its role as a safe haven during difficult periods for the global economy and we believe that will continue. However, the Dollar has been weakening since September[10] last year and remains a risk for non-hedged UK investors in US treasuries.
On balance, absolute yields in both gilts and treasuries look attractive, but at the margin, gilts may have the edge. Fixed income in general, and particularly in the UK, appears to offer good value at these levels.
________________________________
[2] https://www.marketwatch.com/investing/bond/tmbmkgb-10y?countrycode=bx
[3] https://www.marketwatch.com/investing/bond/tmubmusd10y?countrycode=bx
[4] https://www.marketwatch.com/investing/bond/tmbmkgb-02y?countrycode=bx
[5] https://www.marketwatch.com/investing/bond/tmubmusd02y?countrycode=bx
[8] https://tradingeconomics.com/united-kingdom/inflation-cpi
[9] https://www.theia.org/news/press-releases/may-sees-modest-inflows-bond-funds-leading-way
