Why are fund managers turning positive on gilts?

DATA out last week confirmed the UK economy continues to teeter on the edge of recession without falling in. During the three months to April, growth was a meagre 0.1%. The broader perspective is that we’re now in a flat-lining pattern. The UK economy is the same size as it was last July¹.

That’s positive from the point of view of the naysayers who thought we would have entered a recession by now. On the other hand, this confirms a challenging environment for shares, which generally do best with a growth tailwind.

Government bonds, also known as gilts, have their own problems. Inflation is coming down in dribs and drabs but remains stubbornly high overall. Data due out tomorrow could show consumer price inflation falling in May but staying over 8%.

At the same time, there are widespread expectations that the Bank of England will raise interest rates again this Thursday. At 5.1%, two-year UK gilt yields are more than 0.5% higher than the current Bank Rate¹.

Since government bonds provide a fixed income to maturity, they tend to be worth less when inflation or interest rates are high or are expected to rise further.

For short dated bonds, high interest rates are the greatest threat, as returns on risk-free cash become more competitive. High inflation is the greatest danger normally faced by longer dated bonds, which have the bulk of their interest payments and capital returns positioned far out into the future.

However, fund managers have reportedly been turning more positive on gilts, citing the attractive yields on offer after a year of falling prices. PIMCO’s CIO for fixed income said last week that some of his company’s funds now hold overweight gilt positions².

Gilts certainly look appealing compared to their international government counterparts. Benchmark 10-year gilts currently yield about 4.5%, well above the 3.8% available from US Treasuries and 2.5% offered by German bunds of the same maturity³.

Medium dated gilt yields are now at the same levels they were in the aftermath of last September’s mini Budget, when inflation was still running over 10%⁴.

That seems to imply an overly pessimistic view of the UK’s inflation outlook. It also suggests there are now opportunities for investors looking to improve the resilience of their portfolios with bonds.

That might be important, as a further rise in mortgage costs takes its toll on Britain’s economy. More cheap, fixed-rate mortgage deals secured during the 2021 mini property boom are due to end this summer. That’s likely to depress disposable incomes and the ability companies have to pass on their higher costs to consumers.  

There remains the possibility too that the Bank of England goes too far in its quest to return inflation to its 2% target. An overly hawkish strategy could still bring about the recession that some economists fear.

Last year was unusual in that bonds and shares fell together. With growth now apparently treading a tightrope, bonds certainly look as if they have the potential to offer investors some additional security. That, for fund managers as well as individual investors, presents a diversification opportunity that’s becoming increasingly hard to ignore.    

How to invest in bonds

Bond investing can be a complex business but ordinary investors don't have to tackle the task alone. Bond funds can manage a portfolio of bonds for you. Our Select 50 list of favourite funds includes 11 bond fund options.

If you're looking for bond funds that invest specifically in gilts, our Investment Finder tool can also help you. Simply click on 'funds' in section 1 and type 'gilt' in section 2 and a shortlist will be created. 

Sources

¹Bloomberg, 20.06.23
² FT.com, 14.06.23, and Reuters, 12.06.23
³ Bloomberg, 20.06.23
⁴ Bloomberg, 20.06.23

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Please be aware that past performance is not a reliable guide indicator of future returns. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Direct shareholdings should generally form part of a well-diversified portfolio of other investments. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.