Posts tagged ‘gilts’

Linking Fortunes

Markets have begun to think about inflation again. In the US the new President is expected to contribute further towards existing pressure on prices; in Britain the weak pound has led to imported inflation as we saw again only this week. Talk in some quarters has turned, quite reasonably, to inflation protection, and specifically to index-linked bonds. This post is for anyone who is unsure what these are or how they work.

The UK was the first significant issuer of index-linked sovereign debt beginning in 1981. Details of the history and mechanics of the market are available from the Debt Management Office (DMO) website here. But the gist is as follows.

Gilts pay coupon interest semi-annually and repay principal on maturity. In an inflationary environment the real value of these interest and principal payments falls over time. So index-linked gilts, or “linkers”, have their coupon and principal varied in line with the Retail Price Index (RPI, the old measure of inflation, as distinct from the CPI measure which the Bank of England still officially targets).

Complicating things slightly there are two sorts of linker. The first, older variety lag RPI by eight months. This is to allow coupons to accrue on the basis of known values: a payment due in six month’s time will be based on the RPI print from two months ago (the additional month allowing for revision to the initial data release), so there is no uncertainty. Reflecting advances in technology, this type of gilt was superseded in 2005 by another which lags by only three months. This still allows for data revisions but by adjusting coupon and principal payments during accrual periods it follows RPI more closely over the life of the bond.

One further concept to mention is the breakeven inflation rate. This is the rate at which RPI would have to run to equalize returns between conventional and index-linked gilts of the same maturity. At present the benchmark ten-year linker yields -1.8% (these yields are always quoted in real terms). The ten-year conventional gilt yields 1.4%. So if RPI runs at 3.2% over the life of the bonds the linker will end up paying the same as the conventional. This tells investors about the relative value of the two types of security at different times, and about the market’s view on RPI inflation of course.

Index-linked gilts are the key securities for investors looking to protect themselves against UK inflation, as measured by the RPI. Of course in the event of RPI deflation then linker payments are cut rather than increased, which is something to bear in mind, as is the tax treatment: while gilt coupons are taxable as income any change in principal, including the full value of the indexation uplift, is completely tax free.

There are some index-linked corporate bonds in issue too. Like ordinary corporate bonds these pay a spread over government bonds to reflect credit risk and other things, but corporate linkers also track RPI in the same way as gilts. For individuals investing outside a tax wrapper, however, there is bad news. Unlike gilts, the principal uplift on corporate linkers is taxable – and taxable as income at that . . .

Of course the UK is not the only country to issue linkers. There is a sizeable French market, for instance. This offers bonds linked to two indices: the standard CPI and the CPI ex tobacco. Other eurozone countries also have index-linked government bonds in issue, which gives investors the opportunity to take views on respective inflation rates for different economies while bearing the same currency risk.

Some emerging market borrowers also issue linkers. Here, of course, currency volatility can be very high. But if inflation is imported on the back of currency weakness this benefits index-linked securities. In 2015 for instance the Brazilian real lost 49% of its value against the dollar. Year-on-year CPI peaked at 10.7%. And over the course of the year, the conventional government bond maturing in 2025 returned -8.1% while the 2024 linker returned 9.9%. For those interested in emerging market debt, then, there are times when indexation can be a helpful angle – where it is available of course.

Less exotically, the largest issuer of linkers is the US government by way of Treasury Inflation-Protected Securities (“TIPS”). The value of this market is currently $1.2trn (as against £603bn for index-linked gilts). TIPS seem to have found their strongest ever following at present. And not without reason: US breakevens from five years onwards are at about 2%, as against a 20-year average for CPI inflation of 2.2%. Should the US economy be entering a period of above average inflation, therefore, TIPS would offer value relative to conventional Treasuries – while giving dollar investors protection from the real-terms erosion of their wealth of course.

Index-linked securities are generally less volatile than conventionals, or thinking about this another way, even more boring. But there can be a place for dullness, or dependability, in portfolios. And in the event of a serious inflationary outbreak, linkers could well turn out to be the best bet in town. It is no coincidence that the British government first issued them on the back of a report from a committee that started work under Harold Wilson in 1977 – a short time after the oil crisis and a year over which UK inflation averaged 16%.

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20/01/2017 at 6:39 pm

Another Year Over

Well so much for 2015. It was a curious year for the major asset classes and a frustrating one for many investors, including those in the UK. Still, now it has passed we can look at the numbers, identify the winners and losers and remind ourselves that the only reliably immovable feature of the financial landscape is uncertainty.

Starting with UK equity an initially record-breaking year unwound to deliver a disappointing total return of -1% to the FTSE 100 Index. It was a very different story for the mid- and small-cap indices, however, which are less exposed to energy price and currency effects and posted numbers of +11.4% and +9.5% respectively.

On the fixed income front it was a tough year for gilts. Markets which might have been expected to benefit from “risk off” nervousness struggled in the face of the anticipated gradual unwinding of emergency monetary conditions both here and across the Atlantic. The Bank of America Merrill Lynch conventional gilt index managed to return only +0.5% last year with the index-linked index actually losing 1.2%.

Corporate bonds did a little better, with the BoA ML sterling non-gilt benchmark delivering +0.7%. The sterling high yield bond market is tiny (with a face value of £48bn, about the size of Diageo’s market cap), but for what it is worth returned a creditable 5.4%. High yield returns in Europe (+0.8%) and the US (-4.6%) give a more representative idea of what might have been secured by UK-based investors in this asset class, however, and the combined $1.7trn market here was dented by the collapse of borrowers in the US energy sector.

Away from smaller-cap equity and high yield the really bright spot was the property market. Commercial property continued its strong recovery, with price growth underpinning a 19.1% return to the IPD All Property Index (over the year to November, the most recent month for which data is available). And though the residential market lost a little heat last year it was up by 9% on the year to November in price terms using the smoothed HBOS house price series.

Cash rates hardly moved in 2015 as one would expect with the Bank rate frozen at 0.5%: the NS&I Income Bond rate stood at 1.25% with term fixes from the banking sector available a few bp higher. Key exchange rate moves were (as one would also expect) rather more exciting: the pound fell by 5.4% against the dollar, 5.0% against the yen and 4.9% against the Swiss franc while managing to put on 5.4% against the euro.

The most significant market move of all came from commodities with the price of oil down by more than 31% in sterling terms over the course of the year. Gold also fell, the GBP price losing 5.3%.

Finally a brief look at some of the other key international markets (all in local currency terms).

  • It was a disappointing year for US equity with the S&P 500 returning only 1.4%.
  • Europe did better, paying investors 7.4%, while Japan was best of the major markets with a total return of just over 12%.
  • Major government bond markets did very slightly better than gilts with the BoA ML US Treasury Index returning 0.8% and the Euro Government Index 1.6%.
  • More interestingly, the top performers in the eurozone were the weaker peripheral countries with the Italy index returning nearly 5% and Greece – recovering from price depression into the start of the year – delivering over 20%.
  • During the year Greek politics were usurped by the Chinese stock market as the financial world’s bête noire. So it is interesting that the Shanghai Composite Index, despite all its intra-year turmoil, posted a return of +11.2% across 2015 as a whole.

It was a year of turbulence and surprises, though one or two of these numbers did turn out roughly as the consensus had expected at the start of the year. How the consensus, along with the rest of us, will do during 2016 we will all discover in due course …

04/01/2016 at 5:02 pm

Carney Talks!

June 2014 is turning into The Month of the Central Banker. Last week it was the rock star, Mr Draghi, on stage; this week it has been our own (imported) Mr Carney. Yesterday the Governor of the Bank of England set pulses racing when he announced that the base rate, pegged at 0.5% since March 2009, could be heading higher “sooner than markets currently expect.” Never mind that the pace of rises would be “gradual and limited” – nor that there was much else of interest in yesterday’s news about Bank control of mortgage lending criteria, multi-currency facilities and broker lending too. Rates are going up! was the cry that markets took.

The pound, while off its highs for the day, strengthened materially, especially against the euro. The FTSE 100 is back down where it ended April. Short dated gilts took a hit. And market expectations for the base rate, as measured by the three-month LIBOR future, have moved higher in large volume (£234bn worth of the December 2014 contract alone at time of writing).

Yet the moves do not reflect anything like a proper panic so we should not blame Mark Carney for putting on a lousy act. And after all, he has the fundmentals behind him. The UK economy has been growing  strongly – why, we are on track this very quarter to produce the same level of output, in real terms, as we did at our peak over six years ago! And unemployment figures out on Wednesday showed the ILO survey measure down another 0.2% to 6.6%, now lower than in Germany. Pretty soon, even the Bank of England’s pie-in-the-sky inflation modelling will begin to suggest a rate hike is warranted.

There is a more interesting debate to be had, and it is this: how might we expect markets to behave once rate rises become a reality?

With equities down, bonds down, the currency stronger and the property market apparently in the Old Lady’s sights the answer may seem obvious. In any case, with those LIBOR markets now expecting the first rise to come as early as September, it is not that academic.

Doom among asset classes is but rarely universal, however. The market is now pricing for 1-1.25% of tightening in the year to September 2015. This is consistent with the 1.25% occurring from June 2006 to July 2007 and the 1% from October 2003 to August 2004. Taking a proper recession as a starting point, the pace of hikes from July 1994 to February 1995 was a little more aggressive (1.5% over that much shorter period), but policy history and inflation expectations were also different back then.

The gilt market knows all this. But it has had a good year, and might just be expecting inflation over the longer term to remain as subdued as it has been in recent months. In an environment where global activity is picking up, and the Bank of England is sufficiently worried about prices to be hiking base rate for the first time since 2007, there is surely a risk that longer-dated interest rates will have to rise alongside shorter ones.

At the same time, equity markets have generally risen as interest rates have gone up, not fallen, reflecting an alignment of future views on economic, price and earnings growth. Dislocations such as an inflation crisis or the ERM debacle and other factors can skew this logic, but the fact is that over the last 20 calendar years, the base rate has risen across seven of them, and the FTSE 100 index then fallen only twice. When rates have fallen, over eight of those years (they were flat the rest of the time), equities have also fallen twice. We should at least read into this behaviour that the direction of short term interest rates is a poor predictor of equity market performance and not, perhaps, be too concerned about today’s falls as a result.

The message is similar for the currency. The fate of the pound will also hang on what everyone else’s interest rates, growth patterns, equity markets and so on are doing: “rates up, pound up” on anything other than a highly temporary basis is not a view ever worth taking. (Over the longer term, purchasing power might be able to tell us something about the likelihood of sterling’s regaining its pre-Great Recession highs, but that is another story.)

An interesting week for observers of the UK, then, but not one which has provided much of predictive use from short term reactions. Taking a step back, we should view Mr Carney’s announcement as perfectly consistent with a strengthening economic recovery in Britain and around the world – if, of course, that is what we continue to get. There are ideas that might well give us about investment decision making, and it is in the context of such ideas which this week’s news from the Bank should be considered.

13/06/2014 at 5:07 pm

Sheep In Wolf’s Clothing

As this week showed, markets remain jittery. The FTSE 100 had edged up to a new high of 6878 on Wednesday, only a handful points short of its all-time closing peak of 6930 in 1999, only to give up its gains yesterday in the biggest daily fall for a month. At the same time, the ten year gilt yield – which had been stuck in a range of between 2.6% and 2.8% for three months – broke lower in the biggest one day fall since January to reach its lowest point since last July. And continued euro weakness saw the pound reach a new high of 0.814 (or 1.23 for those of us who prefer our sterling exchange rates the right way round), its strongest level against the euro since January 2013.

In fact, listen to some fund managers and 2014 has been a shocker. Technology shares, which were supposed to keep going up, have underperformed, with the NASDAQ down in absolute terms and 4% behind the S&P 500 for the year to date. Indeed, some of the big internet names in particular have taken a major bath: Amazon is down 26% and LinkedIn down 33%. Last year’s massive bull trend in Japan is nowhere to be seen with the Nikkei 225 down 13%, comfortably the worst performer of any major market. Emerging markets have been outperforming (by 5% over the last three months). Duncan’s horses have turned wild in nature and gone for a picnic. For many participants it has been a bruising time.

And yet in truth, things have not been as exciting as it has sometimes felt. Equity market volatility has not been anything like as high as it was when the taper tantrum kicked off just under a year ago. Indeed, some swift linear regression to the FTSE 100 over the last 12 months shows that its line of best fit has risen 4.5% in price terms over the period. Coupled with a dividend yield of about 4% and CPI inflation of an average 2.3% over the same period and you’re looking at a real return of 6.2%, which is so near to the textbook number for expected long run returns to equity as makes no difference. Putting it another way: the equity market, despite patches of volatility and some sector fireworks, has in aggregate been quite boring – and that was always the consensus view for the major markets going in to 2014.

The economic data has been unspectacular too. Eurozone GDP for Q1 out yesterday was a little weaker than expected, but there was nothing to derail the expectation of dull and sluggish – but positive – growth this year. Employment data has continued to show measured strengthening at home and in the US, while in both countries, activity indicators have stayed healthy though below recent peaks. There have been no signs of further deterioration in EM, nor any evidence of anything beyond a gradual uptick where numbers have been positive. On the political front the Ukrainian situation remains worrying, but there has not yet been anything to match the annexation of the Crimea and there have been no more big surprises elsewhere.

In fact wherever you look – eurozone bond markets, precious metals, credit spreads, oil and gas – there have been occasional episodes of excitement, but nowhere near enough to keep the casual viewer watching. It has been a dull old time. (Unsurprisingly this will have benefited dull old portfolios. Income investors, both within equity markets and as holders of bonds, will have done pretty well.)

So these jittery markets have not really been as dangerous as they seem. But since nothing lasts forever, the question is: how worried should we be about what comes after the boredom? Will “risk on” be unharnessed as recovery continues? Or will there be another shock, or disappointment, which will make the last few months seem like the calm before the storm?

Perhaps the most sensible approach for investors to take in these circumstances is to resist the temptation to actually do very much. There has been little change in fundamental data to challenge whatever positions they may be taking, and in many markets, rarely enough volatility to suit those waiting either for a buying opportunity or to take profits. Best to stick to one’s views, save some trading costs, and see what happens next …

16/05/2014 at 3:53 pm

New Bod, Old Tricks

The eagerly-anticipated arrival of Mr Mark Carney as new Governor of the Bank of England apparently produced its first real news this week. Presiding over the regular release of the Bank’s quarterly Inflation Report on Wednesday, Governor Carney announced that UK interest rates will not start going up until the ILO measure of unemployment falls to 7%. This measure has not moved much over the last four years, stuck around an average of 8%, so who is to say when this might happen? But not to worry: the condition is subject to three “knockouts”, which are in fact two. If inflation looks like it might be getting troublesome, then rates might go up. And if the financial system looks like it is imploding due to the low level of interest rates – how this might occur is yet to be clarified – then a change will also be considered.

This generated some coverage, though market reaction was understandably confused. The pound rose somewhat, trade weighted sterling bouncing back to about what it averaged in June. On the other hand stocks fell, with the FTSE 100 falling by 93 points on the day. Meanwhile, gilts bobbled around a bit before finally deciding to do nothing at all.

For the benefit of readers however, this blog can state that there is one new development of note: namely, that the supposed commitment to a 2% CPI target over a 2-year forecast horizon has been effectively abandoned. Its replacement is a supposed commitment to a 2.5% CPI target over a 1.5-2 year forecast horizon (“knockout” number one).

Nobody seems to have noticed this usurpation of the Exchequer but it doesn’t matter anyway. The Bank’s inflation forecasts have been garbage for years. They have consistently underestimated CPI over their forecast period in good times and bad while doing everything they can to drive it higher.

From the volume of comment in the business pages one might find this hard to believe. But it is August, they have to have something to write about and it is true: other than this one change nothing is different. The first paragraph of all the Inflation Reports since February 2004, when CPI took the limelight from RPIX, has read along these lines:

In order to maintain price stability, the Government has set the Bank’s Monetary Policy Committee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%. Subject to that, the MPC is also required to support the Government’s economic policy, including its objectives for growth and employment.

Mr Carney’s predecessor was explicitly prioritizing this supposedly secondary aim as far back as January 2011. The emphasis is not new. In fact even the soft target for unemployment is a poor show compared with targeting nominal GDP growth, as some had been hoping Carney would do.

In other words the Bank will carry on ignoring inflation and doing everything it can to push up activity and job numbers (beyond what it has already done: not much).

We must be fair to Mark Carney. As well as presiding over monetary policy he also has a firm to run, and has let it be known that he wants more women at the top of the Old Lady, with a view to one of them becoming Governor in the fullness of time. He is likely to be pre-empted in this ambition by the Fed if recent speculation is to be believed, but then they were the first ones to start linking monetary tightening to specific unemployment figures too so this cannot bother him.

In any event, his legacy is unlikely to be overshadowed by that of the newly-ennobled Mervyn King. All those years at the helm and the only prices he managed to contain were those of the sandwiches in the Bank’s canteen.

Whether Mr Carney manages any better on the inflationary front remains to be seen. The early signs are not encouraging.

09/08/2013 at 5:17 pm

Riding For A Fall

Each year, Barclays publishes its Equity Gilt Study. Among other things, this magisterial document records inflation-adjusted total returns to UK shares, gilts and cash for each year since 1899. On average, government bonds have returned something in the order of 1-2%, plus inflation, per year. Last year’s returns of 17% – or 21% in the case of index linked gilts – can therefore be regarded as anomalous.

They have also left gilts offering dismally poor value. Ten year yields have been hovering at about 2%, in line with the Bank of England’s supposed target for CPI inflation, and significantly below the most recently reported level of 3.6%. Most starkly, perhaps, all yields on index linked gilts with maturities shorter than twenty years are negative. An investor buying the ten year index linked benchmark and holding it to maturity would be locking in an annual real return of -0.5%.

Gilts, of course, have been seen as a safe haven from the storm that rocked European bond markets over the autumn. They have also enjoyed ongoing support from the Bank of England’s programme of quantitative easing, and from expectations that the base rate will not rise until some time in 2014.

While peripheral eurozone bond markets continue to attract scrutiny, however, the fact is that they have made a strong recovery over the last few weeks. Interest rate expectations change: twelve months ago, the same futures markets that are betting on unchanged rates for the next two years were expecting an increase of 2.5% over the same period. And the Bank will not buy gilts forever. (Indeed, even the increased size of its asset programme at £325bn pales next to the £594bn of net gilt issuance which the Debt Management Office expects to have completed since the start of the recession – see here for the conceptual logic of this.)

It is looking more and more as if the world has moved on from the rabid bearishness of  a few months ago. So far, the gilt market has yet to move with it. It puts this blog in mind of the staple gag in those old Hollywood cartoons where a character runs off the edge of a cliff without noticing and manages to defy gravity for a few impossible seconds, legs paddling furiously in mid air, before looking down and giving in to the inevitable.

Of course, a world calamity that sees the UK collapse into deflation could entail some more upside for the bond market. (The ten year government yield in Japan is 0.98%.) Without such an outcome, however, gilts are surely poised to fall some distance before they reconnect with reality.

24/02/2012 at 3:59 pm


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