Few investment opportunities that have stood out over the past 20 years seemed as compelling at the time as shorting Japanese Government Bonds (JGBs) after yields slipped below 2 per cent 18 years ago.
Anecdotally, this was a popular trade for the more sophisticated types in the hedge fund world. Eventually, the trade rather darkly earned the moniker ‘the widow maker’. Following the financial crisis, JGB yields continued to spiral lower until, almost inevitably, the 10-year note finally sank into negative territory in February. But are gilts investable for retail clients on current yields? Or should buyers be institutionalised (in either sense)?
In December, after a long wait, the Federal Reserve lifted US interest rates, seven years after they were slashed to near zero during the financial crisis. Since then the banking sector has been restored to health, the housing market revived and unemployment levels have halved.
The Fed clearly intended this to be the first in a series of rate rises, but recent events in markets have really put the need for further tightening in question. Disinflationary pulses continue to reverberate across the global economy and evidence is mounting that there is too much capacity in swathes of industries.
Whether the current episode is a continuation of the trend or marks a final spasm is unknown. What we do know is that many of the central banks that have lifted interest rates since 2009 have subsequently been obliged to reverse them. It is not inconceivable that the Fed is making a similar policy mistake.
As a standalone proposition, gilts are eye-wateringly expensive. Inverting a 1.5 per cent yield gives a price to yield ratio of 66 times. This is expensive, even for the raciest of growth shares, which rarely trade on price-to-earnings ratios ahead of this. Yet the income growth potential from gilts is zilch. The 10-year return of 15 per cent – plus a trifle of compound interest – on offer from gilts seems to provide far more risk than return.
Capital values could easily suffer double-digit losses in the short term if yields were to spike. After all, why shouldn’t gilts be trading on yields closer to 3 per cent or 4 per cent in an economy where inflation is targeted at 2 per cent and growth rates are about 2 per cent?
Despite these valuation misgivings, gilts can still be an important component of a balanced portfolio. Put simply, they perform a role in a diversified portfolio that is difficult to replicate using other assets.
Good portfolio construction is all about blending assets that complement one another. If one part of a portfolio is zigging, it is good to be holding something else that is zagging.
Portfolios are generally made up of assets that contain a number of risks. These include: equity, currency, liquidity, credit quality and interest rates. A problem with this is that during a crisis, correlations across a wide range of assets begin to rise and any diversification benefits diminish. One of the few asset types that rise in value in these periods are government bonds.
This is a valuable feature of gilts and very few other assets provide this sort of support during sell-offs in risk assets. Equity options are one, but these are expensive to buy. In contrast, you are still paid to hold gilts.
With interest rates so low, there may be a temptation to move into corporate debt. While these instruments do provide a higher yield, credit spreads are liable to widen in a crisis so the diversification benefits are muted.
However, holding gilts may not always be a good idea. A big risk is if inflation begins to revive. Inflation is lethal for conventional fixed income securities and periods of rising inflation can also affect equity ratings. This is well worth bearing in mind. But just at the moment, disinflation and indeed deflation seems more of a risk.
The outlook remains confused and there is no guarantee that cash rates will rise. So while gilt yields are admittedly low, they still have an important role to play.
Jason Broomer is head of investment at Square Mile