Are You Prepared for Gilts to get Exciting?Nov 9, 2018

For years, investors holding gilts in their portfolios have reaped the rewards of steadily declining yields. But as political and economic uncertainties mount up, David Zahn, manager Franklin UK Gilt Fund, sees signs of change on the horizon.

Gilts get exciting


 

Boring by Design

For many investors, UK government bonds (Gilts) are an asset class that is boring by design. Still, over the last 30 years, investors holding Gilts in their portfolios have reaped the rewards of steadily declining yields. But as political and economic uncertainties mount up, we see signs of change on the horizon.

In the face of heightened volatility, we expect the Gilt market to move considerably more than it has in the past. And we believe the passive solutions to Gilts investing of the past may not prove as successful in the future.

Our analysis has highlighted a number of scenarios looming in the near-term that could take passive Gilt investors on an uncomfortable ride that might prove too exciting for some. That is why we believe the time is ripe for investors with a Gilts component of their portfolios to consider adopting an active approach.

Insurance That Has Paid Off

Historically, investors in Gilt funds have tended to invest passively, seeing that investment as a component of their “risk-off” portfolio.

Gilts have often been used to offset volatility in other components of an investor’s portfolio. And thanks to the substantial decline in yields over the past 30 years, both globally and in the UK specifically, Gilts have been a contributor to overall returns.

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

Uncertainty Ahead

Trying to predict the future has rarely been a successful strategy for investors. Today’s investors face an alarming array of situations with the capacity to dramatically impact fixed income markets globally and in the UK in particular. Many of these scenarios have multiple potential outcomes, each affecting markets differently.

In the face of these scenarios, not to mention the potential for unexpected developments, passive Gilt investors should be braced for a bumpy ride, in our view.

Gilts: What Might Lie Ahead

ScenarioOutcomeGilt Yields
No Deal “Hard” Brexit If the UK leaves the EU without a trade deal, most commentators predict UK growth would slow considerably. In the medium term the UK government would act to jump-start the economy. But in the short term we’d expect Gilt yields to fall on the back of a flight to safety amid a backdrop of increased risk and an uncertain landscape.
Negotiated Brexit Gilt markets are pricing in a lot of uncertainty around Brexit. In our view if the two sides were to negotiate a resolution, Gilt yields would likely rise significantly.
Durable Inflation Given current rates of inflation, we’d normally expect to see Gilt yields higher than they currently are. Should we start to see signs of durable inflation, Gilt yields would likely rise.
Significantly Increased Government Spending The latest UK Budget promised an end to austerity and higher public spending. As we get a clearer idea of the details of that higher spending, we’d expect to see Gilt yields moving.
Impeachment proceedings in US UK Gilts and US Treasuries have historically been quite correlated, so we think political uncertainty in the US or in Europe could make Gilt yields decline.
More problems in the eurozone An intensification of the Italy/EU stand-off could push Bund yields lower and with them Gilt yields lower

The Case for Active Management of Gilts

A passive investment will track market turbulence. An active manager, on the other hand, is able to use the volatility to an investor’s advantage by actively managing duration1, curve positioning and allocate away from Gilts to other governments when opportunities present themselves.

Gilts are a very liquid asset so an active manager can move duration in their portfolios longer or shorter depending on their analysis of conditions as well as move positioning along the curve to take advantage of mispricings.

Volatility can provide an active investor with the opportunity to add value even if Gilt yields are the same at one point and another.

For a passive manager if yield on a 10-year Gilt is 1.5% now and 1.5% in a year’s time, they will earn 1.5%. But an active manager can potentially take advantage of volatility in the intervening year to make higher returns.

Chart: Duration Management is Essential in the Current Market Environment

Chart: Managing Duration is Essential for Gilts

At times of heightened volatility, an active manager is able to benefit and as the market is very liquid, the portfolio can be moved quickly. Investors that insist on remaining on the passive Gilts rollercoaster will certainly experience the volatility but will likely miss the opportunity to benefit from it.


The comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.

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1. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.

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