When is a safe haven not a safe haven? Gilts have proved a distinctly unsafe ‘safe haven’ in recent weeks. Can they reclaim their crown?
- The average UK gilt portfolio is down 23% over the past six months.
- The Bank of England has intervened in gilt markets, but has made it clear that its support is temporary and limited.
- The UK 10 year gilt continues to move steadily higher and now sits at 4.6%.
Any investor using UK gilts as ‘disaster insurance’ for their portfolio may now be regretting their choice. The average UK gilt portfolio is down 23% over the past six months, the type of performance an investor might expect from a high risk small cap, rather than the core of a portfolio.
The reasons behind the weakness are complex – and show that the forces operating in government bond markets are often more involved than they first appear. Pension funds had hedged against falling bond yields. They needed this protection in case they can’t meet their liabilities. Rising yields pushed out the costs of those hedges, prompting margin calls. To meet margin calls, the pension funds sold gilts, pushing up gilt yields even further – and so the spiral continued.
The Bank of England stepped in, but has made it clear that its support is temporary and limited. It has told pension funds to get their houses in order. Partly, it is worried its actions will be interpreted as a resumption of quantitative easing at a time when inflationary pressures are mounting. It also can’t be seen to be backstopping policy errors from the government.
It is a high risk move. The UK 10 year gilt continues to move steadily higher and, at the time of writing, was sitting at around 4.6%. That puts it 2.35% ahead of the current Bank of England base rate. The impact is already being felt in the real economy as mortgage rates rise and household budgets are squeezed even further.
That said, it is difficult to see what would reverse the problem. Chancellor Kwarteng has brought forward his budget, where he will let markets know where he is going to find the estimated £60bn or so that he will need to fund tax cuts properly and calm markets.
Even if he does pull a rabbit out of the hat, it is difficult to see how the gilt market recovers significantly. The 4.5% yield may look superficially attractive, but the risks are finely balanced and its position as a safe haven for investors looks severely compromised. Investment managers are either turning to US treasuries or to cash to fulfil the ‘disaster insurance’ role in portfolios. Given the strong dollar and the potential for further rate rises from the Federal Reserve – and notwithstanding inflationary pressures - cash appears to be one of the only true safe havens today.
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