Do you need to own government bonds?
May 15th, 2009
These conditions are not easy for investors. No-one has been here before. Interest rates are at new lows. Government borrowing is at a new high. The world economy has just been knocked severely. The US and UK authorities are pursuing large programmes of “quantitative easing”.
It’s at times like this that I find it best to look at the obvious. I try to keep it simple. It leads me to the conclusion that owning gilts is unlikely to enable you to pay the pensions, the charitable donations and the family bills in the years ahead.
If you lend your money to the UK government today, you will receive the promise of income at somewhere between 0.75% and 4.5% a year, depending on how long you lend them the money for. These are low yields by historical standards.
The income from these fixed income bonds does not grow. If you buy and hold them you will still be getting the same low rate of interest in two or three year’s time, when the investment world may look very different.
Most of the bonds are currently selling above their par or repayment value. If you hold them until the government pays you back, you can be sure of a capital loss. If you want to sell them before they repay, you will make a capital loss if interest rates rise from here.
Yesterday gilts rose. They rose because the Bank of England was gloomy about the economy. Indeed the Bank is now, for the first time for some time, more gloomy than many in the markets. The bank implied that it would keep short-term interest rates down for a long time. In its gloomy frame of mind it is likely to carry on buying gilts itself, keeping longer-term interest rates lower than they otherwise would be.
That does not make me want to leap in and buy some. It is true that the Bank can try to force long-term yields down more – pushing bond prices up – by buying in more gilts at higher prices. However, the more it buys in under the Quantitative Easing programme, the more it has to sell back if and when it decides to reverse the policy.
The Budget book told us that the government needs to sell £220 billion of gilts in 2009-10 as well as £21.6bn of Treasury Bills. Out of this it will repay £16.6 billion of maturing gilts and meet its large budget deficit.
All this implies to me that at some stage interest rates, both long and short, have to go up again. Clever traders may be able to make some money from a further gilt-edged rally, selling gilts on good days to the Bank and buying them back on bad days from the Debt Management Office. There may be a further burst of enthusiasm for gilts based on deflation scares.
For long-term funds I would just ask, how low do you think long-term interest rates can go against this background? And do you think 3% on your money is enough? Gilts are only a good deal if you think inflation is going to zero or below and staying there, and if you think the government can sell what it’s got to sell without damaging the prices.
I think you are better off out of gilts whilst the government still is prepared to buy them.
