Talk of a bubble brewing in the gilt market has investors in a quandry – 3070

21st September 2010

The bond market is currently in a quandary. Gilts are ostensibly the most defensive position for a bond manager, but given that they are paying below inflation in many cases they appear to offer little upside.

Indeed many analysts are talking of a nascent ‘bubble' in this area of the market. But if the economic outlook worsens, as many believe it will, it is difficult to see investors pouring money into the higher yielding end of the market, in spite of more compelling valuations.

How are investors dealing with this dilemma?

Certainly, in the short-term it has done nothing to stem the appetite for bonds, but as this article from Fundstrategy suggests, the smart money is heading for the higher yielding and emerging market debt end of the market. 

Andrew Yeadon, head of multi-manager, at Schroders has a significant overweight in the high yield sector.

He says: "There is better value the further investors move towards high yield and away from gilts. This positioned is premised on the fact that default rates are relatively low and valuations look compelling.

"We are shorting gilts in a controlled fashion at the moment. They look over-valued and ought to move higher. They move to yield 5% any time soon, but when the 10Y gilt hit 2.9%, it was a step too far.

"They are likely to drift higher as chances of a double dip diminish."

A browse around data provider site Trustnet suggests that strategic bond managers – those fixed income investors who can roam their way up and down the credit spectrum as they see fit – are a little more cautious.

The top-performing strategic bond managers over the past year are generally clustering around the B to BBB level, believing that this offers the best risk/reward trade off.

There are plenty of people who go one step further, suggesting that investors should be avoiding fixed income altogether.

Ngata on the Motley Fool for example, says: "Investments in fixed interest securities is, today, crazy. No matter if they are government guaranteed. When inflation forces interest rates sky high, bondholders will be crucified on the cross of their own ignorance."

But is there still an argument for investing in the higher quality end of the bond market? After all, even at the top end of the investment grade market, the spreads over government bonds are at historic highs. It is possible to argue that this is because gilts are yielding historic lows, but investors are still receiving a reasonable income yield relative to base rates.

If interest rates are to stay low for longer, which is most analysts' central scenario, government bonds yields may be historically low, but they could go lower.

This article from Yahoo Finance sees an analyst from RBS predict that pan-European bond yields could go as low as 2%. There is still plenty of structural instability across the global economy that could prompt further risk aversion and a flight to quality assets.

Certainly, many investors are glad that they have hung onto gilts. As TheSkyRacer on Motley Fool says: "Where have all the prophets of doom gone? I thought gilts were sitting on a pile of explosives and an unprecedented fall was a certainty. Actually, my bond portfolio has done rather well lately.

"Ahhh, but there has been a euro crisis since then. Oh well, there you go, that explains it."

While interest rates remain low, the much heralded implosion in the gilt market is relatively unlikely. However, that there will not be a crash or could gain a percent or two doesn't necessarily make a compelling investment case. As ever, it depends on an investor's head for heights.

 

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