Why Asset Managers are Buying UK Government Debt Again
The UK government bond market has seen a rebound in buyers after a significant sell-off in response to the official figures that showed wages rising at a faster pace than expected, raising concerns about inflation and future interest rate hikes. Major investment firms such as BlackRock and Legal & General Investment Management have changed their outlook on UK debt, citing attractive yields and fundamental value, especially in longer maturities.
BlackRock highlighted the attractiveness of gilts as prices have returned to levels seen during the 2022 fiscal turmoil. Legal & General Investment Management expects the market to self-correct as mortgage market conditions tighten, ultimately leading to lower consumption growth and decreasing rates. Andrew Balls, Chief Investment Officer for Global Fixed Income at PIMCO, acknowledged that his firm did not believe the UK has more of a structural inflation problem than the US or Europe, and some portfolios were overweight as a “relative value” trade against US bonds.
However, analysts have warned that the UK bond market is not recession-proof. George Cole, an economist at Goldman Sachs, called the UK market inefficient and insecure, offering a risk of higher inflation. Additionally, Ales Koutny, Head of International Rates at Vanguard, warned that the UK’s toxic combination of stubbornly high inflation, higher global yields, and political risks could limit the scale of any UK bond rally.
At present, UK benchmark 10-year yields are still playing catch-up with US Treasury yields, reflecting the rising central bank policy rates. The extra yield on benchmark gilts above 10-year Treasuries is now at its highest level since 2009, resulting in asset managers seeing value in the bonds.
An Expanded Perspective
The UK market’s future is uncertain, as wages reach their highest point outside the COVID-19 period, sparking a rally in gilt yields. While analysts remain optimistic about the UK’s relative value trade against US bonds, others see the country’s inefficient and insecure market offering a significant risk of high inflation.
The pandemic and Brexit compounded the UK economy and created uncertainty within the country’s major sectors. As per the Office of National Statistics, inflation was at 2.5% in June 2021, exceeding the Bank of England’s (BOE) initial inflation target of 2%. Despite this, the central bank decides to hold interest rates at current levels in favor of the British economy’s growth in 2021.
However, higher UK wage growth and rising prices of goods and services, including energy, housing, and transport, may compel BOE to follow its foreign counterparts in tightening policies to stop inflation. Currently, traders expect the UK interest rates to rise by more than a percentage point to 5.72% by the end of 2021.
Political risks that could considerably affect the bond markets are also present. The UK government intends to increase spending in infrastructure and public services to aid in recovery after the pandemic, and eventually, balance the budget. These endeavours may lead to borrowing that will put upward pressure on interest rates, leading to a bond market sell-off.
Final Thoughts
Investors are once again buying UK government bonds at attractive yields. While some analysts remain optimistic, others warn of the UK’s inefficient and insecure market and high inflation risks due to higher wage growth and rising prices. BOE’s maintained interest rates balance growth with inflation, but traders now expect UK interest rates to rise more than a percentage point by year-end. Additionally, the increased government spending in infrastructure and public services can contribute to borrowing, leading to a bond sell-off.
Summary:
Major asset managers like BlackRock and Legal & General Investment Management have switched their outlook on UK debt from neutral to positive. Their decision is based on their perception of attractive yields and the present fundamental value of UK bonds. Moreover, some portfolios are overweight, representing a relative value trade with US bonds. Bond market traders expect UK interest rates to rise by more than a percentage point to 5.72% by year-end. However, some analysts warn of the UK’s high inflation risks and potential bond sell-off due to government spending.
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Major asset managers are buying up UK government debt again, tempted by the higher yields on offer after selling off much faster than in other major bond markets.
Two-year gilts suffered a strong sell-off on Tuesday, with yields up more than 0.25 percentage points to 4.89%, the highest level since 2008. However, they fell slightly on Wednesday in early trading at 4.85%. The movements follow the official figures which showed wages had risen at their fastest pace recorded outside the coronavirus period, adding to concerns about stubbornly high inflation and further interest rate hikes.
Yields on longer-dated 10-year bonds, which are less sensitive to interest rate expectations, had a more subdued response, but still rose 0.09 percentage points to 4, 43%.
Price moves extend a dismal year for gilts versus their US and European counterparts, with benchmark 10-year yields rising as much as 0.76 percentage points year-to-date, reflecting a price tumble . By contrast, German and US benchmark yields are currently trading at levels lower than at the start of the year, at around 2.43% and 3.80%, respectively.
Some large investors think the gaping gap between UK bonds and their German and US counterparts presents a buying opportunity.
“For years we were underweight [gilts] then we had the revaluation and we are now at a level where 10-year yields look quite attractive relative to the United States,” said Andrew Balls, chief investment officer for global fixed income at Pimco, the most largest active bond fund manager in the world.
Balls said Pimco didn’t have a strong view on gilts, but some global portfolios were overweight as a “relative value” trade against US bonds. He added that his firm did not believe the UK had more of a structural inflation problem than the US or Europe, as underlying inflation was “broadly in the same ballpark”.
Core inflation, which excludes volatility in food and energy prices, rose 5.5% in the United States in the year to April, from 5.6 % in the euro area and 6.8% in the UK. Official figures from the United States showed on Tuesday that Core US consumer price inflation rose 0.4% in May, corresponding to the increase in April.
Legal & General Investment Management, the UK’s largest asset manager, changed its tactical outlook on gilts from neutral to positive in early June, a trade that has fared poorly. But Chris Jeffery, the group’s head of inflation rates and strategy, said he expected the moves to be “partially self-correcting” as mortgage market conditions tighten, which would ultimately lead to lower consumption growth, putting downward pressure on rates.
For most of the past decade, US Treasury yields have outpaced their UK counterparts, reflecting rising central bank policy rates. But that has reversed and the extra yield on benchmark gilts above 10-year Treasuries is now at its highest level since 2009.
BlackRock is also looking more favorably on gilts, with an underweight position in long-term US Treasuries and Eurozone government bonds while being neutral on UK debt.
“We find gilt yields attractive as they have rallied near levels reached during the 2022 fiscal turmoil,” the group said in its weekly market commentary on Monday. Yields on 10-year gilts peaked at 4.5% last fall in the wake of the crisis, while two-year gilts rose above “mini” budget levels on Tuesday.
Craig Inches, head of rates and treasury at Royal London Asset Management, which manages £150bn of assets, added that “gilts are now starting to have good fundamental value, especially at longer maturities.” .
“Over the past few weeks we have increased our duration position and moved the UK overweight,” he said. He added that while there was “a risk” of base rates hitting 6%, in this scenario it would be “very unlikely” for longer-term yields to exceed 5% due to the coming recession. located at this level. would induce.
Traders have dramatically raised their outlook for UK interest rates in recent months, now betting they will rise more than a percentage point to 5.72% by the end of the year.
However, some analysts have warned of more problems ahead for gilts. “Other economies offer efficiency and security. The UK offers a lot of inflation,” said George Cole, an economist at Goldman Sachs.
Ales Koutny, head of international rates at Vanguard, said the UK was getting “a lot of attention as high yields start to attract buyers” but argued it was “not yet” the time. to start buying gilts.
“It’s true that valuations have become very attractive, the gap to the US is now as high as it was during the depths of the ‘mini’ fiscal crisis,” he said. But he added that while bonds rebounded quickly last fall, the risks this time around were different.
“A toxic combination of stubbornly high inflation, higher global yields and political risks should limit the scale of any UK bond rally,” he said.
https://www.ft.com/content/77135f9d-acf6-456e-857d-c29bf870834f
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