August 8, 2011 / 6:05 AM / 8 years ago

Analysis - Debt doubts could brake gilts' safety rally

LONDON (Reuters) - Government bond yields have fallen to record lows as investors seek shelter from the euro zone crisis, worries about U.S. debt and global growth concerns, but holders may be in for a nasty shock should Britain’s own debt problems resurface.

Gilts’ reputation as a safe haven could take a knock later this year, when the government will have to account for the effect of a year of sluggish growth on the public finances.

The government has been quick to boast that steps to run down a record deficit by 2015 have bolstered the appeal of British bonds, helping them shrug off unfavourable comparisons with debt-laden Greece.

“I think what we are seeing is ... concern that other countries don’t have the same kind of very clear-cut plan to get their public finances back into order that we have put in place here in the UK,” said Treasury minister Justine Greening as global stock markets plunged on Friday, pushing gilt yields to fresh lows.

The tumble in yields partly reflects a weakening economic outlook and expectations that the Bank of England will keep monetary policy loose for at least another 18 months and could even embark on another round of monetary stimulus.

But the yield on 10-year gilts has plunged by almost 80 basis points in the last month alone, compared with a slump of 70 basis points in the two weeks after the Bank of England launched its quantitative easing programme in March 2009.

Even gilt bulls such as Andy Chaytor at RBS acknowledge that safety is relative.

“There may come a time, when this gets bad enough, when the UK’s credit quality is called into question and you may want to sell gilts, but it’s a minimum of 50 basis points away from here,” he said, referring to the 10-year yield, which hit a record low of 2.59 percent on Friday.


Some investors are already wary. Disappointingly weak growth, which would be exacerbated by a renewed global economic downturn, may put Britain at risk of falling behind its debt targets, leaving gilts vulnerable to a dramatic repricing.

“There are two ways for the gilt market to get repriced — a good way, where real money investors start to pressure for higher yields. There’s a bad way as well, though, which is if there is any hesitancy in pushing through the fiscal measures,” said Philip Laing at Standard Life Investments.

Laing, who overseas a gilts portfolio worth around 13.7 billion pounds, reckons a conventional repricing could see 10-year gilts trading at 80-100 basis points over German Bunds. The spread is 37 basis points now.

But a sharper repricing could be ugly, Laing warned, and risk gilts being tarred with the same brush as debt of the euro zone’s most indebted states. “They (the government) must be thinking that whatever happens they can’t show any nerves on the fiscal side.”


The government has so far made little progress in its aim to virtually eliminate a budget deficit of almost 10 percent of gross domestic product over the next four years.

With the economy virtually stagnant for the last nine months, and the outlook darkening, cutting the deficit is becoming even more of an uphill struggle. Economic weakness limits tax revenues and drives up spending on welfare payments.

Even the Office for Budget Responsibility — an independent fiscal watchdog — has admitted that its assumption of 1.7 percent growth this year is looking optimistic.

Sceptics say investors have only turned to gilts for want of any better options. “For gilts, the fact that there’s no imminent crisis makes them, amongst others, the destination of choice, certainly for UK investors,” said Marc Ostwald, a strategist at brokerage Monument Securities.

Some note the rally has been led by futures contracts — notional instruments which allow investors to hedge in the market, but which are not always indicative of underlying demand in the cash market. The September gilt future has leapt by almost 7 full points since the start of this month.

“In terms of straight switching out of other markets into gilts, although that probably has been happening, we don’t have any underlying evidence,” said Nomura strategist Sean Maloney. He calculates that safe-haven flows have accounted for between 20 and 60 basis points of the fall in the 10-year gilt yield.

Leading think-tank the National Institute of Social and Economic Research has questioned gilts’ safe-haven status, observing that a weak growth outlook had meant the fall in yields had not been accompanied by a rise in the pound.

Nonetheless, the premium that investors demand to hold gilts versus their German counterparts has been narrowing for more than a year, and for a brief period in late July, gilts were even viewed as a safer bet than U.S. Treasuries.

So for now, gilts look well supported.

Even Monument Securities’ gilt-sceptic Ostwald admits there may be some substance to the UK bond market rally, noting that yields on 30-year gilts have broken out of the 4-5 percent range they have occupied for most of the last 12 years.

But he warns the market may start getting jittery ahead of the government’s autumn update on the public finances, expected towards the end of this year.

“If we get the public finances numbers in September and see Osborne’s not hitting his target, then actually the UK isn’t better than anywhere else, particularly because it has the most emphatic inflation problem,” Ostwald said.

“The lower we drive these yields in gilts, the sharper will be the corrective reaction.”

Additional reporting by Naomi Tajitsu, Sven Egenter, Adrian Croft and David Milliken; Editing by Catherine Evans

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