“U.K. gilts have become increasingly attractive for foreign investors,” said Laureline Renaud-Chatelain, a fixed-income strategist at Pictet Wealth Management. “They offer the highest yields in the core sovereign bond space, even once hedging costs are taken into account.”
Ever since the fallout from Liz Truss’ plans for vast fiscal stimulus, gilts have been the worst performing fixed-income market across the Group-of-10 nations. They also missed out on a rally over the past three months, amid signs U.K. inflation is proving stickier than in the U.S. and Europe.
Money markets imply about 95 basis points in additional BOE hikes toward the end of the year, putting the key rate close to 5.5%, according to swaps tied to the central bank’s meetings. That compares to an expected peak rate of 3.75% for the euro area and 5.5% for the U.S.
“We think this might be a bit overdone,” BlackRock Investment Institute strategists led by Jean Boivin wrote in a note. “We closed our previous underweight on U.K. gilts as yields returned near levels reached during September’s turmoil.”
The U.K.’s 10-year yield is at 4.2% — the second highest among advanced economies. That’s 2.8% in euros terms and 3.9% in dollars, according to Bloomberg calculations, more than the 2.4% and 3.7% on offer for benchmark German and U.S. securities.
The last time yields were this high was in September, when a rapid drop in gilt prices forced defined benefit pension schemes using LDI strategies to sell their holdings to raise cash for margin calls, a vicious cycle that pushed prices even lower. For NatWest Markets, a reprise is unlikely, but that doesn’t mean yields will go down right away.
“A rise back up to post-mini budget highs should be nowhere near as problematic as it was last year,” Imogen Bachra, head of U.K. rates strategy at NatWest Markets, wrote in a note. “But this hardly a stand-out reason to go long. If anything, it serves as more of a cap on the upside in yields rather than a trigger for a downward shift.”
BlackRock and Legal & General Investment Management also advocate investors proceed with caution, favoring shorter bonds over longer ones as the BOE policy outlook is still cloudy.
Pictet Wealth Management said investor confidence on the U.K. bond market will depend on the government and policymakers staying the course in keeping the public debt trajectory on a sustainable path. Britain is suffering economic stagnation and the worst cost of living increases among the Group of Seven.
“The selloff has been triggered by stronger growth and inflation news in the last few months,” said Legal & General Investment Management’s CIO Sonja Laud. “Investors therefore need to be prepared for more short-term volatility.”
