Lending money to the government isn't exactly the most daredevil investment idea, unless you happen to live in Athens. For UK government bonds, the traditional virtue is that you can not only sleep soundly at night but doze off during the day too, knowing that your money is safe and will be returned with interest.
However, we now live in what the Chinese proverb would describe as "interesting times". Assumptions of absolute safety in any kind of investment died in the queues for Northern Rock deposits back in 2007, and the banking crisis that followed. The tentacles of liabilities and promises snaking between banks, customers and governments have been exposed as never before. Everywhere we look, from pensions to government supplier deals, contractual promises are being rewritten. Above all, we now know that there will be a tsunami of new UK government bonds issued over the next decade or so, to fund a national debt that is already close to a trillion pounds and is expected to balloon to £1.6 trillion by 2014-15, according to the Institute of Fiscal Studies.
Lean times for gilts?
So does that mean we can no longer trust gilts? Well, perhaps some of those revisions to government pension and spending promises mean we can trust them more. Back in March, credit rating agency S&P issued a very downbeat report on the UK. "In the absence of a strong fiscal consolidation plan... the UK may approach a debt burden incompatible with an AAA rating," analysts at the agency wrote.
Although no-one was seriously suggesting that Britain would be unable to service its debts unless growing deficits were addressed, we all know that increased supply, all things being equal, leads to lower prices. If that happened, not only would the returns from gilts diminish for investors who hold them directly, but the performance of almost every funded UK pension would be affected. After 20 years in which gilts have produced tremendous returns, we may be faced with some fairly lean years.
There is some good news, though. Three factors have emerged since S&P's last report, one boosting gilt demand and two trimming supply. The first is the trouble next door in the eurozone, which boosts the relative attractions of gilts to overseas investors. The second is the single-minded commitment by the new coalition government to tackle the public spending deficit. Finally, there is the news that this year at least borrowing was a little lower than expected, so this year gilts to the value of £165bn will be issued rather than the £185bn forecast in April.
The comparison with the eurozone has been particularly favourable. International investors haven't just been worried about the prospect of a Greek default, or even the weaknesses in Portugal, Spain and Ireland. It is the whole rigid euro mechanism that makes fiscal and monetary adjustment so hard that is undermining the safe-haven status of the eurozone. On top of that, there are worries about interference in the markets, for example Germany's ban on naked short-selling.
"The UK now seems a safe haven compared with the eurozone," said Howard Archer, economist at IHS Global Insight.
Here, despite a weak economy and an addiction to debt both public and private, there remains an arsenal of economic adjustment weapons denied to any member of the EU, or indeed a debt-mired state within the US such as California. By being able to let our currency slide against that of trading partners, and stimulate the economy through low interest rates, Britain can light its own economic afterburners.
Investors have voted with their feet. Britain's sale of £8bn-worth of gilts at the end of June was almost twice oversubscribed. Consequently, the 30-year bonds were priced at an unusually low yield of 4.234 per cent.
The new chancellor's toughness has gone down particularly well with overseas investors. From 2000 to 2008, overseas holdings of gilts rose from 10 per cent of the total to a peak of 36 per cent, according to the figures from the Debt Management Office. After falling by seven points in 2008 and 2009, anecdotal evidence from sovereign wealth funds, overseas banks and financial institutions, indicates the proportion of gilts held abroad may now be climbing again. Since February, when the Greek debt crisis began to emerge, the yield on gilts has fallen by a full point to 3.36 per cent, while yields on debt issued by the most troubled EU nations have risen.
Still, with UK yields near record lows, it is hard to see how this Goldilocks pricing environment can be maintained. "It is hard to see gilt yields staying down at this level for very long," said Mr Archer. "Much depends on how well the government hits its deficit targets, and on whether inflation trends down. If it doesn’t then this could spook the markets a bit."
'Bubble' might seem too strong a word for the rather gentle world of gilts, but if history is any guide, then the returns from gilts are likely to revert to lagging behind shares. So does that mean gilts will be a poor investment? Not necessarily. It is something about the unique nature of the gilt that makes it so attractive.
"It depends why you buy a gilt," said Michael Dyson, head of fixed income at Evolution Securities. "If you want a safe haven and modest but predictable returns, then gilts serve their purpose."
Gilts, inflation and history
Gilts may seem dull, but over the past 20 years they have left shares standing. The Barclays Capital Equity Gilt Study shows that, since 1990, gilts have returned a real annual average of 5.4 per cent. Not only is that better than shares have returned over the period (4.6 per cent), but it is far better than the 5.0 per cent annual average that equities have returned over the full 120 years of the survey – and totally out of touch with the long-term bond returns of 1.2 per cent.
The root cause of these returns is actually quite simple. The UK, and indeed most of the developed world, has been on a long slow descent from inflation. Inflation is the mortal enemy of all bonds, whose returns are fixed in nominal terms.
That £100 spent in 2010 on a 20-year gilt is still only going to be £100 redeemed in 2030, whatever inflation has done to its spending power in the meantime. A share, meanwhile, is a real asset, a finite share of a living, growing enterprise which should be able to increase the prices of its goods and services. So crushing inflationary expectations is much better news for bonds than it is for shares. Though the prospect of lower interest rates is good for both gilts and shares, it is the bond the craves the affirmation that the value of money is stable.
In theory, with inflation reasonably low and interest rates at a floor, the pricing situation for gilts could not be much improved except by a slide into deflation. However, the consequences for an indebted government of deflation are almost unthinkable. A stagnant economy and a debt burden that gets bigger in real terms as prices fall would be a recipe for disaster. The trouble is that letting inflation rise is also a risk. “You can’t guarantee that a little bit of inflation will stay just a little bit,” noted economist Howard Archer of IHS Global Insight.