In truth, though, we don’t need such silly talk to see that gilts are risky. We just need to know the maths of bonds, and in particular the idea of modified duration. This measures how much a bond changes in price for a given change in yield.
And it alerts us to a problem – that when yields are low, even a moderate rise in yields means a big fall in price, especially for longer-dated bonds. For example, a one percentage point rise in yields would cut the price of a 10-year bond by 9 per cent, and that of a 30-year one by more than 22 per cent.
Such a move would, however, only take yields back to 2018’s levels. Which was a time of low inflation, low growth and talk of a shortage of safe assets and secular stagnation. Even if the macroeconomic climate stays the same, therefore, gilt investors could face big losses if the weather changes a little.
To some extent, markets expect this. The yield curve is pricing in a rise in five-year yields from zero now to 0.6 per cent in five years’ time. Longer-dated yields are higher than shorter-dated ones to give investors an income to compensate for a likely capital loss.
Which poses the question: why might yields rise?
It’s unlikely to be because of fears of high government borrowing. The same high private savings and weak economy that is causing the government to borrow a lot also creates strong demand for government bonds around the world. Yes, quantitative easing is helping to suppress yields – but such easing is a response to weak output. The Bank of England’s buying of bonds is just one channel through which a weak economy reduces yields.
In fact, gilt yields are more likely to rise as government borrowing falls. It’s possible that economic activity will bounce back strongly next year if a successful vaccine programme unleashes a consumer boom financed by the savings many of us have built up this year. In such an event, gilts would sell off as investors shift into riskier growth-sensitive assets such as equities.
Of course, this is only a possibility, not a certainty. But it’s one that isn’t fully priced in. Harvard University’s Matthew Rabin has shown that we systematically mis-predict our future preferences because we project our present ones into the future and fail to see that they will change. This means that even though investors are now anticipating a strong economic recovery, they might not be fully anticipating its impact upon their appetite for risk. If so, yields would rise as the upturn materialises – implying big losses on longer-dated gilts.
Such losses, however, are easily diversifiable. The same increased appetite for risk that would cause losses on gilts would also drive up equities. Yes, gilts are a risky investment if we view them in isolation. But we shouldn’t do so. What matters is your portfolio as a whole. And viewed from this perspective, gilts are not so risky.
There is, however, a caveat to this. History warns us that gilts and equities do sometimes fall at the same time. One way in which this can happen is if monetary policy tightens by more than investors previously expected.
You might think this is a small risk now, as both the Fed and Bank of England have both said they will keep interest rates near zero until they are confident that inflation is on or above target. However, it is possible that mismatches between the patterns of demand and supply would cause inflation to rise: this is common in the early phases of recoveries from recession. This could trigger fears of higher rates and hence a sell-off of bonds and equities together.
This is no huge problem, because the inflation caused by such mismatches tends to be moderate and short-lived. It is, however, a modest threat to portfolios of equities and gilts. Which is one reason why balanced portfolios should contain some cash.
