Expensive insurance

Despite this, there is in fact a case for holding them. It’s as an insurance policy. Anything that reduces investors’ expectations for economic growth or appetite for risk would see share prices fall but gilt prices rise as investors switch into safer assets.

Better still for gilts would be a recession. This would be very likely to cause some combination of more quantitative easing and interest rate cuts, possibly to below zero as is the case in the eurozone and Japan. That would drive gilt yields down. Ten-year yields are negative in Japan, Germany and Switzerland. It’s not inconceivable they could become so here.

This would see huge capital gains on gilts because of a brute mathematical fact called modified duration. For bonds with low yields and long maturities, a given change in yields produces a big change in prices. For a 10-year conventional gilt a one percentage point fall in yields would cause a 10 per cent capital gain. For the longest-dated index-linked gilt, it would give a gain of almost 50 per cent. These would be nice profits to have at a time when shares would be slumping and returns on cash shrinking.

Granted, you might think such a scenario implausible. But then we thought negative real yields were implausible a few years ago. And we must invest on the basis of a distribution of possible future scenarios rather than just a central-case forecast. The small probability of nice returns on gilts at a time when shares do badly might be worth having.

Or not. Gilts only insure us against some types of fall in share prices. In the mid-1970s, for example, equities and gilts both lost heavily as inflation rose. Although there’s little chance of big rises in inflation in the next few months, there are two other ways in which both assets could fall at the same time.

One would be if investors were to switch into cash, say because of expectations of rising interest rates: until the mid-90s, this was a common cause of shares and bonds falling together.

Another would be if global investors were to lose their appetite for sterling-denominated assets. The UK’s big current account deficit means that foreigners’ holdings of UK assets must rise over time. It might require lower prices (and thus higher expected returns) to induce them to buy these assets.

Perhaps a bigger danger for gilts, however, comes if share prices rise. A better economic outlook would probably see gilt prices fall as investors switch into growth-sensitive assets such as equities and out of bonds. In this context, duration becomes the enemy of gilt investors: it generates large losses for a given rise in yields.

On balance, then, the case for gilts seems weak, except as insurance against the small but nasty danger of recession. And this insurance comes at a high cost.

We might in fact be able to get it cheaper elsewhere. If we do get a recession, it is likely that sterling would fall. This would clearly happen if the recession is confined to the UK – as a weaker economy should mean a weaker currency. But it’s also likely if (or when) we get a global recession. Because this would cause investors around the world to become more cautious, it would make them dump riskier assets in favour of safer ones. And sterling is a riskier asset than some other currencies: it slumped in 2008 partly for this reason.

This implies that foreign currencies such as euros, dollars or Swiss francs might well do a similar job to gilts in paying off well in a recession. But they would do so without the drawback of large losses in normal times: the default expectation for future exchange rates should be that they follow a random walk around their current level. And while a big rise in sterling and losses on foreign currency are possible, they are perhaps less likely than those on gilts. So maybe there is a cheaper alternative to gilts.