Gilts remain favourite but further drop in yields undesirable

Further falls in UK gilt yields would be undesirable for many investors, with the risk/reward profile of the asset class already significantly skewed to the downside.

Gilt yields have tumbled to record lows following the announcement at the start of August by the Bank of England that it was cutting UK interest rates to 0.25%, as well as expanding quantitative easing.

The central bank shifted rates to a new record low to counteract lead indicators which suggested the UK economy is slowing rapidly. In response, parts of the gilt market saw yields drop into negative territory, while benchmark 10-year gilt yields also fell to new depths, trading as low as 0.501%1.

Declining yields are putting increasing pressure on specific parts of the market, with pension funds in particular faced with a real challenge in terms of funding future liabilities.

UK gilt futures are now at record highs, as is the long end of the UK gilt market, and the total return for some gilts year-to-date has been over 50%,” he said.
“But these heroic gains mean investors are now paying 50% more to get twice as much risk in terms of duration, which has moved out to 28 years for 50-year gilts.
UK pension funds are firmly in the firing line because they use rates in the gilt market to determine how much additional funding they will require to meet future liabilities.

The move to record low yields has therefore widened funding gaps in pension schemes and the situation could deteriorate further. Valuations across government bond markets are very rich, and further falls in gilt yields would be an issue for pension funds.

While the group’s central investment case was for 10-year gilt yields to remain in positive territory, it remains a possibility that they follow other benchmark government bond indices into the realm of negative rates.

While events such as the recent rise for headline inflation may prevent 10-year gilt yields falling to zero, a shock – such as a terrible growth number – could force them lower, therefore, you can never say never.

Adrian Hull, senior investment specialist Fixed Income at Kames 

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