In the gilts world it is no surprise to be surprised

Geoff Lunt, the manager of the HSBC Gilt & Fixed Interest fund, answers questions from Adam Lewis.

Geoff Lunt is a fund manager in HSBC Global Asset Management’s fixed income team and runs the HSBC
Gilt & Fixed Interest fund.

Q: How has the Bank of England’s quantitative easing affected the gilt market?
A: Over the past week [to March 9] it has made a profound difference in terms of the yield level and the yield curve. Generally yields have fallen significantly, more so in UK gilts than other international government bond markets. I would be surprised if UK gilts were not the best-performing markets over the past four trading sessions [as measured from March 5].

The Bank of England said it would buy £75 billion of assets over the next three months and said most of this will be in gilts. As a result gilt prices soared. The Bank of England said it would buy in the five-to-25-year part of the yield curve and this has had a positive impact on that area of the yield curve.

Q: How is this reflected in your port­folio and what is the duration?
A: In 2009 we have not taken any significant duration positions in the fund. The reason for this is that everything has been so uncertain and volatility has been great. In these circumstances we are mainly being moved about by regulatory announcements and other things that are hard to forecast.

For some, last week’s quant easing by the Bank of England was a surprise. The general consensus before the announcement was that the Bank would be buying yields in the five-to-eight-year area of the curve. The feeling was that the Bank would avoid the long end of the market. However, instead they said they would buy a spread of gilts, which did come as a surprise to us as well. We weren’t surprised by the surprise because we live in an unpredictable time. This was an unprecedented announcement, therefore you have to expect the unexpected.

The portfolio has not really changed. We were slightly overweight in the 20-year sector of the yield curve as this is where the yields were the highest. This helped the fund’s performance and allowed us to take some recent profits.

Q: How does your position differ from last year?
A: In 2008 we were long duration for most of the year. This reflected the view that the slowdown would be significant and sharp. This meant the fund’s duration positions were longer than the benchmark and we did well last year as a result. However, since the turn of the year we have moved the duration bets in the fund closer to the benchmark to reflect the extreme uncertainty.

Q: What impact have the low interest rates had on gilts?
A: It steepens the yield curve significantly. As such there are now low yields at the short end of the curve and higher yields at the long end of the curve. This means that the 30-50-year gilts are offering a 4% yield, whereas the two-year gilts are only offering just over 1%. So the yield you get from gilts is very different dependent on where you are positioned on the yield curve.

Q: What type of returns would you expect from a gilt fund in these markets?
A: The return is entirely dependent on where you are positioned and what happens to yields in the future. If yields rise from here an investor will get less than the average yield of 3.3%. If yields fall they could get more than this. This is where the skill of the fund manager is all important.

We are trying to anticipate when government bond yields will rise and when we think this will happen our fund will try to have as a low a duration position as possible. There will be a time when they do rise but there is still a lot of uncertainty. It is reasonable to say that interest rates will stay low for a considerable time yet and an economic recovery is still many months away. This means a sharp rise in yields is unlikely in the near future.

Q: What are the longer-term prospects for the asset class?
A: Over the next few years there will continue to be significant gilt issuance and the budget deficit will continue to be plugged by this. However, at some point we expect gilt yields to return to a similar point to where they were a few years ago.

Q: Can you use derivatives – such as credit default swaps (CDSs) – to go short on credit?
A: We can. We are currently short of a couple of credit names. We believe these names are particularly vulnerable to the poor economic environment.

Q: How do you respond to those who say a gilt market bubble has emerged?
A: We would not describe the conditions in the gilt market as bubble-like. You think of bubbles when a vast amount of money flows into a new market because of the belief that someone will buy that asset at a higher price than you paid for it. However, with gilts we think people are buying the asset because of the asset class’s safe haven status, in which the capital and income are guaranteed by the government. People are also buying gilts because interest rates are so low, meaning the returns they get from bank accounts are very low. They can get a better return from a gilt fund over the next year or so, which means they are buying them for their intrinsic value.

Q: Corporate bonds are popular. What is your view on the asset class?
A: A lot of people have jumped into the asset class because spreads are historically high. However, the absolute level of yields is not that high . If you dissect the corporate bond market you will see the names you don’t want to buy are those that offer a high yield. The names you do want to buy are not offering much of a yield. There will be opportunities in the corporate bond market, but this could still be several months away and you have to be careful which names you buy.

Q: Are corporate bonds more risky than they are perceived to be?
A: Yes. If you buy them you need a manager who has rigorously researched the asset class and the individual issuers. Get the right manager, though, and there is a great opportunity to be had.

Q: How do you construct the portfolio?
A: Some 95% of the fund’s net asset value has to be invested in gilts. We apply four risks to the fund. The first is duration. We can go longer or shorter than the benchmark dependent on whether we think yields will go up or down. Second, is the yield curve, we want to be in the part of the curve where yields will fall the most. Third, is the ability to go long or short to credit using CDS indices. Finally, we can buy protection on individual credits if we believe these credits will deteriorate. This is because we don’t want to expose the fund to single name default risk.

Q: Describe the management team?
A: Including myself, there are four fund managers who all have an input into all the risks that go into the fund. It is very much a team-based approach.