Franklin Templeton’s Zahn: Should investors be holding gilts?

An air of uncertainty hangs over the economic prospects for the United Kingdom as it prepares to break away from the European Union, but while markets loathe uncertainty, UK government bonds offer some value right now.

Historically many investors in gilt funds tended to invest passively, seeing that investment as a component of their “risk-off” portfolio. With bonds having seen a substantial decline in yields over the past 30 years, both globally and in the UK specifically, that might be considered a prudent approach.

Now however, amid expectations of intensifying volatility and, in time, potentially higher yields, there’s a strong argument to reconsider a more active approach to gilt investing.

Indeed, active fixed income managers seek to add value by looking at the actions of central banks, considering the implications of political actions and analysing growth and inflation trends. As such, given the United Kingdom’s current uncertain situation, there’s considerable scope for such an approach.

How might Brexit impact gilts?

The continuing complexity of the Brexit negotiations and the United Kingdom’s changing relationships with Europe and the rest of the world, suggests there’s likely to be more volatility than one would normally expect over the coming years.

Ultimately a negotiated exit from the EU would make sense for both sides. A non-negotiated – or ‘hard’ – Brexit would likely hurt both the United Kingdom and Europe. And, in that instance, yields could go down substantially from where we are now. On the other hand, a negotiated settlement could potentially see gilt yields rising.

In addition, it is important to remember that the Bank of England’s quantitative easing programme for gilts has now come to an end, meaning that one of the biggest buyers of gilts has disappeared. That is likely lead to a modest rise in yields. So instead of declining yields, it is possible we will see gilt yields move sideways – possibly within a range – in quite a volatile fashion and we could eventually see yields start to rise.

With this is mind, actively managing a fixed income portfolio is probably more important now than it has been at any time in the last several decades. Ultimately, the management of the UK economy and management of its government bonds comes down to what type of Brexit there is.

Inflation creeping in

Despite the UK economy growing quite nicely in recent quarters (gross domestic product grew 2.2 per cent in the fourth quarter of 2017) we would expect that to slow to under 2 per cent this year, because of Brexit uncertainty.

In addition, many people have already started to see inflation creeping into their household bills; poor harvests in certain areas supplying crops for Europe have put an upward pressure on food prices. Furthermore, the weaker pound has meant imports such as oil and food costs more.

Forecasts now suggest inflation could rise above 3 per cent this year, and at that level some observers might consider that bonds no longer offer value. However, in our opinion the main drivers of the rise – the precipitous drop in the sterling and the rebounding oil price – are unlikely to be repeated at the same magnitudes so quickly.

These effects tend to be more transitory and we think that’s something the Bank of England’s Monetary Policy Committee will likely take into account. We would expect committee members to conclude that this is temporary increase in inflation that should be followed by a return back to the target inflation range of around 2 per cent in due course.

As a result, we’d not expect that the MPC would feel the need to adjust its approach dramatically in the short-term and should continue to keep the Bank of England on an accommodative path – probably not as accommodative as it has been, but accommodative all the same.

As a result, gilts will likely offer reasonable value for investors over the coming years and, due to increased political and economic volatility, now is the time to consider a more active approach to managing the gilt component within portfolios.

David Zahn is head of European fixed income, Franklin Templeton Fixed Income Group