Vanguard UK Government Bond Index Fund (IE00B1S75820) has had its rating downgraded by research company Morningstar, sparking debate over if and how investors should be exposed to the asset, which had been considered to be a safe haven.
Morningstar has downgraded Vanguard UK Government Bond Index from its highest rating of gold to silver for reasons including the fund's exposure to rising interest rates. The company is concerned about duration, a measure of how sensitive bonds are to increasing interest rates. Vanguard UK Government Bond Index tracks Bloomberg Barclays UK Government Float Adjusted Bond index, which has an average duration of 12.1 years. A rise in interest rates is often followed by a fall in the capital value of a bond, and the longer a bond has until it matures, the greater the impact. For every percentage point rise in interest rates a bond's capital value could fall by 1 percentage point for each year of duration.
Jose Garcia-Zarate, associate director of passive strategies research at Morningstar, said that while a low-cost fund such as Vanguard UK Government Bond Index can be a good way to access this asset, there are also some inherent risks.
Morningstar still highly rates this fund, which has an ongoing charge of 0.15 per cent, but Mr Garcia-Zarate said it has been downgraded based on its ability to outperform active and passive peer funds over the long term.
"We think that taking a low-cost passive investing approach to this market is very likely to deliver above-average returns over the long term," he explained. "However, irrespective of [the fund], the structure of the UK gilt market is such that there could be room for some highly experienced active managers to add value. This is because of the long duration bias of the market."
| Performance |
| Fund/benchmark | 1-yr total return (%) | 3-yr cumulative return (%) | 5-yr cumulative return (%) |
| Vanguard UK Government Bond Index fund | -0.61 | 12.97 | 23.05 |
| Bloomberg Barclays Global Aggregate UK Government Float Adjusted | -0.49 | 13.44 | 23.91 |
| IA UK Gilts sector average | -0.92 | 11.2 | 21.38 |
| Source: FE Analyics, as at 07.03.18 |
However, Peter Sleep, senior portfolio manager at Seven Investment Management, is surprised by Morningstar's rationale, in particular, downgrading a fund based on a market's duration.
"I knew Morningstar rated exchange traded funds (ETFs) and trackers but I did not realise that they also made market calls [on duration]," he said. "If there is a market setback [long duration] assets can go up when everything else goes down and act as an insurance for a conservative investor. I would say that in a narrow market such as [UK government bonds] it is very difficult [for active managers] to outperform as the opportunity set is so low. I would be interested to see how many managers are on [Morningstar's] buy list."
James McManus, investment manager at Nutmeg, added: "The top five active fund managers in terms of assets [in the Investment Association (IA) UK Gilts sector] have an average duration not significantly different to [the benchmark]."
But Ryan Hughes, head of fund selection at broker AJ Bell, said Morningstar has highlighted a growing and inherent risk in the UK government bond market.
"If we are entering a period where interest rates rise then it comes with inherent risks," he said. "Rating a fund based on its duration is a change [from the norm], but I understand the reasoning."
There are only a few UK government bond funds dedicated to short duration, and only a handful of active ones that manage the duration exposure of gilts. These include Royal London Short Duration Gilts (GB00BD050C73), which currently has a duration of two years and is managed by Craig Inches. It has an ongoing charge of 0.3 per cent.
Passive options include iShares UK Gilts 0-5yr UCITS ETF (IGLS) with an ongoing charge of 0.2 per cent and Lyxor FTSE Actuaries UK Gilts 0-5Y UCITS ETF (GIL5), which charges 0.06 per cent. Both products limit duration to five years.
