The past few weeks have most certainly been a concerning rollercoaster for UK Bond markets. The media have absolutely loved it! It’s been a complete feeding frenzy.
Anywhere you turn, you will hear the repeated assertion that the Government Mini Budget ‘caused’ Gilt yields to rise to dangerously high proportions, thus hurting Gilt prices and Global confidence in the Pound.
This is simply not the full picture.
Gilt yields have been rising all year. I know that I have explained this to many of our clients by now, so forgive me repeating myself but here is a brief explanation.
When the government wants to borrow money, it sells Gilts to the markets. There is usually no shortage of investors lining up to buy these securities. After the Great Financial Crash of 2008, the Bank of England purchased huge amounts of Gilts – thus pushing up the prices.
When prices are high, Governments don’t need to offer a high interest rate to attract those investors. Buy what happens if sentiment suddenly turns and the prices start to fall?
Answer: The yields have to go up.
Sentiment has been turning against UK Gilts for the past nine months or so. This has been primarily down to the slow response to inflation by the Bank of England.
Their refusal to put up interest rates as swiftly as the US Federal Reserve (Fed), whilst promising to withdraw their Gilt purchases, had already destroyed Gilt prices – pushing up Gilt yields on the year by over 250% before the UK Government launched their un-costed budget.
Interestingly, the US Treasury market (their equivalent to Gilts) had also seen a huge increase in Treasury yields as their own prices fell. So US markets are equally disturbed by the actions of their own central bank.
The un-costed mini budget, and the subsequent apparent weakness of Government in the UK has most certainly compounded what was already a worrying situation.
In addition to all of this, the Bank of England now has to confront something called LDI’s.
Liability Driven Investments are effectively a form of insurance that allows large Defined Benefit Pension fund managers the chance to underpin the value of assets such as UK Gilts.
Why would they choose to do this?
Defined Benefit Pension fund managers, have to promise to pay out a fixed income to their members. You may have heard of these schemes more commonly referred to as ‘Final Salary’ Pensions and they are most commonly found within the Public Sector as they are so expensive to run.
As members move closer towards retirement, the fund manager will follow conventional wisdom (and regulation) and move a larger percentage of the fund into a historically more secure asset called ….. Gilts. This usually helps to dampen down any volatility, and ensures that the fund manager has enough liquidity to then pay out the incomes to their retiring members.
With me so far?
Ok, so the fund managers ran something called modified duration calculations some years back (as we did at Thomas and Thomas). They could see that Gilts looked far more vulnerable to a price drop – if the Bank of England should suddenly change their approach.
Enter LDI’s.
Fund managers started purchased hedging instruments (or insurances) called LDI’s. The idea was that these LDI’s would ‘pay out’ to the fund manager if Gilts should fall in price below a certain level.
Over the past weeks, Gilts have indeed fallen, and the fund managers have cashed in their LDI’s.
So far so good.
Only it appears that there was a problem, which the Bank of England are suddenly trying to deal with.
Any hedging instrument has to be underpinned or ‘backed’ by something. In other words, if I am providing an LDI, I need to have a readily available and fairly secure asset that I can quickly cash on the markets to meet my obligation.
I can already hear you groan.
Yep, you guessed it. The very asset being sold to meet these obligations, is UK Gilts. This means that swathes of Gilts are now being sold to try and bail out Final Salary Pension Schemes that need to protect their ever falling Gilt values.
A vicious circle if ever I saw one.
So the Bank of England stepped in with a promise to buy back Gilts from the market – effectively restarting Quantitative Easing at the same time as promising Quantitative Tightening. In a way, I feel sympathy for the Bank of England, as they are desperately trying to prevent a rout on UK Gilt (and Bond) markets.
Their announcement today that they will now stop buying any more Gilts on Friday is designed to tell providers of LDI’s to sell their Gilt holdings quickly whilst there is a large buyer in the market. Mr Bailey has then promised that this is the end of the buying programme.
Honestly, it is anyone’s guess as to what happens next. It could be that having a clear direction and ending ‘hokey cokey’ Easing/ Tightening actually calms investor sentiment. On the other hand, it could mean that confidence in the UK Gilt market falls further after Friday.
So what on earth does this all mean and are we doomed?
Let’s start with the important headlines.
Any of our clients with Thomas and Thomas portfolios will not be invested directly into purely Gilt funds or Final Salary Pension funds. If you have a Personal Pension, this is not what the media are currently referring to.
As many of our clients will recall, we sold the last of our Gilt fund holdings at the start of 2021 as we worried that interest rate rises and Quantitative Tightening could well be around the corner.
Our client portfolios are very well diversified. Indeed, they are far more affected by what happens in the US and Global Equity Markets. Right now, Equity Markets are sulking. We call this a ‘taper tantrum’ where Equity Markets effectively sympathise with the plight of Bond Markets.
This is really down to one hard fact. Markets love liquidity. Rising interest rates cut off liquidity.
In the US, we are now seeing more and more discomfort at the FED policy of constant rate hikes. Inflation is a nightmare all over the world because of the Pandemic and Russian invasion of Ukraine. However, there is only so far that interest rate rises can go to try and modify inflation. We believe that the FED may meet far greater political resistance after the results of the Mid-Term Elections next month.
Global Equity Markets are best currently described like a catapult. The further you pull back on the elastic, the greater the force of the ‘snap back’. If you ever wanted to see clues as to what will happen once the FED stops pulling back on the elastic – just look at the US Equity Market charts over the past year and note the rapid ‘false recoveries’ when markets have wrongly guessed that interest rate rises will soften. It’s simply a matter of time.
So, in summary, yes the UK Gilt market and indeed the strength of the Pound is in a serious mess right now. If you are lending money to someone, you want to know that they are credible. The UK Government are not coming across in that way currently – but don’t be fooled – they can’t actually do much to change the situation.
Fascinatingly, if yields continue to rise on UK Gilts, there will come a point where investors pile in to buy them. Why? They are simply being compensated with such high interest payments that it becomes worth the risk.
The only game in town right now is US interest rates. They affect everything. Until the FED stops raising rates with such aggression, the rest of the world currencies such as the Pound, the Yen and Euro will take a thumping.
The last thought I would leave you with today is this. Within our portfolios, we always ask the question: where else is better? If there is no plausible alternative, we hold.
The same can be said for Investment Asset Classes. The alternative to Equities and Bonds is Property. Many investors have piled into Property in recent months, as this asset class has not yet suffered in the way that Equities and Bonds have. This is a fools’ errand in our view.
With around 50% of UK mortgage fixed rates due to end in 2023, it is highly likely to expect Property prices to crash at a later point (barring further Government intervention). Property is always a much longer cyclical investment. It can take many years for Property values to come back, where Equities can literally turn on a single piece of news.
So we are not doomed! It’s grim out there right now, and there is the possibility that things get worse before they get better, but we are in the best possible place with our clients’ portfolios and experience tells me firmly that we will be celebrating successes before too long.
As ever, we are here for you all the way. My very best wishes. Darren
