Concerns over the UK’s fiscal outlook and gilt market have intensified, but the reality is more nuanced than the headlines suggest. David Roberts, Co-Portfolio Manager of the Nedgroup Investments Global Strategic Bond Fund, explores how UK bonds really compare with their global peers, why Japan’s recent turmoil offers timely lessons, and what shifting yield dynamics may mean for investors weighing their next move.
Much has been made of the dire state of UK public finances. If you read the popular press – the UK is unloved by international investors whom amongst other things shun the domestic gilt market. Who would lend to the UK Government for 10-years never mind 30-years?
Yes, yields have risen, and bond prices fallen in recent days. But it may surprise you to know that 30-year UK yields are slightly lower than they were back in mid-January. Significantly lower than in August.
With all the political uncertainty around it could be said that UK bonds have done well. With many expecting a post budget ‘Liz Truss’ moment, is it too late to get out of the UK bond market?
Gilts are still amongst the best performer in major bond markets these past three months. With doubt about Reeves’ commitment to her fiscal pledges reaching new highs, what could the future look like for the UK?
Japan
We need to look no further than the world’s second biggest bond market – Japan, where huge levels of government borrowing were seemingly starting to come under control. Surely the Central Bank would raise rates, choking inflation in the process.
Apparently not, as three years of CPI above target is still not enough to convince the Bank of Japan to raise rates to any great degree.
The new Japanese Prime Minister is widely expected to launch a huge fiscal stimulus – into an economy growing close to trend, with low unemployment. What has even the suspicion of such a package done for Japanese Government Bonds (JGB)?
Since January, 30-year yields in Japan have risen wildly. A year ago, they were 3% less than UK equivalents. Today, that has fallen close to 2%
In price terms, those bonds fell 20% relative to Gilts. Putting a huge strain on Japanese public finances.
Recently, I bought 30 Japanese bonds for the first time in my career – which started in the 1980s.
Why?
Size – First and foremost I run a bond fund. A real bond fund with a historic correlation to the global bond market of around 0.9.
That means on average if the bond market rises on a particular day, the fund goes up 90% of the time. Of course, as with everything investment related the past is no guarantee of the future. Japan is nearly 15% of that global bond index. JGB performance has been appalling. I owned none.
Absolute value may still be challenging. However, such was the under performance relative to other parts of the global bond market, that it was sensible to reduce my underweight. At time of writing, we are around half index weight. A toe dipped in the water, rather than plunging in headfirst perhaps?
Value – JGBs have fallen relative to other markets such as the UK. So, the relative value is better. However, ten- and thirty-year bond yields are also at multi decade highs, price lows. Ten-year yields are now the highest this century.
In absolute yield terms, few in the market have ever seen a better buying opportunity
Support – The Bank of Japan is notorious for intervention, both through direct purchases and “yield curve control” where they tell the market the level they “expect” bonds to trade at.
Neither can be precluded, especially if the other central banks such as the US Fed don’t cut interest rates and the Yen continues to depreciate.
It’s this rogue element that prevented me shorting Japanese bonds when yields were low. Sometimes it is nice to have the rogue on your side.
Travel and arrive – The UK may be waiting another Liz Truss moment. Arguably Japan has just had theirs. Although it has been more six months than a moment. And could continue for some time to come.
Lessons for domestic bond investors
- Treat headlines with care. News of the UK calling in the IMF is somewhat exaggerated with the UK economy in better shape than much of the G7
- Fiscal discipline is important. Sometimes there’s a shock and bonds drop. Other times, as with Japan it plays out over many months
- The UK may not be in as bad a fiscal position as Japan. Yet. Allowing politics to get in the way of sound economic policy is not a good look. Worse still is inconsistent economic policy
- UK bond yields are little changed from a year ago
What does all that mean?
Yields in Japan have risen fast. In many respects they look good outright and relative value. The worst could be behind them, Liz Truss firmly in the rear-view mirror.
UK Gilt investors have not done as badly as the popular press would have us believe.
Is that a sign of UK stability? Or has the better than reported performance given an opportunity to get out – perhaps diversifying into global bonds?
Who knows? Maybe investors have even looked at Japan.
