Sovereign debt diversification comes with extreme cost, says SIG’s Smears

Adam Smears, portfolio manager and head of Research at Skandia Investment Group says that the record low yield on UK gilts is the cost of diversifying into an asset with contractual returns.

Recently UK yields have moved below 1.8% as the market remembered the unresolved issues in the eurozone. These yields are at historic low levels and the question is why? 1.8% is not a lot given inflation is growing at 3.5% – you would be better off heading into your local Tesco (supermarket) buying a basket of goods with your savings and selling it on (just remember to freeze the perishables!) Gilt yields are at all-time lows and definitely don’t represent good value, so why are they at this level?

Well clearly there aren’t many places to store your money that are safe in the event of a messy end in Europe. When markets go through a distinct risk off environment, previously diversified assets start to behave very similarly – they all go down. Sovereign bonds, particularly if they are considered safe, are one of the few places that provide a contractual return, regardless of the risk environment, which is the reason why they provide real diversification when you need it most. Add the fact that they are liquid and you have a powerful asset for those times when you are feeling less brave.

The price you pay for this diversification is pretty extreme. Assuming the benchmark 10 year Gilts was to collapse down to the yield on a 10 Year JGB, you would gain 8.9%! However, if the UK Gilt was to rise to match the current rate of inflation of 3.6%, you would lose 16.8% of your capital. This latter scenario does not require a lot of imagination either – bonds over time should pay a premium above inflation, otherwise, one would utilise the aforementioned supermarkets asset allocation approach.

In the Skandia Strategic Bond Fund, we have been slowly raising cash from our more interest rate sensitive assets as yields declined. We believe that the diversification that interest rates provide is now a bit too expensive.

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