Some pundits are predicting a crash in the bond market this year. I'm not convinced.
You may have read comments in the press that there’s a ‘gilt bubble.’ In other words, gilt prices are way too high, and there’s a strong chance that the market will collapse this year. That’s the theory anyway.
A collapse in the government bond market would affect most of us – it would lead to higher interest rates on long-term mortgages, push up annuities for new retirees and reduce the value of many peoples’ investments and pension pots.
So why do some people think there’s going to be a crash?
1. They look expensive on many measures
As I write the yield on ten-year gilts is just 2.08%. So if you bought a ten-year gilt today, you’d only get an annual income of 2.08% for the next ten years, plus the face value of the bond at the end of the term.
Obviously just over 2% a year isn’t a great return, especially when inflation is more like 3%. What’s more, the yield on ten-year gilts was around 5% in 2008. So gilt prices have gone up a lot, yields have fallen, and gilts look expensive on many measures.
2. Europe looks more stable
The Eurozone doesn’t appear to be on the verge of collapse anymore, although I wouldn’t rule out a collapse in the longer term.
Some investors bought gilts in 2010/11 because they wanted a ‘safe haven’ from storms elsewhere. Now things have calmed down a little in the Eurozone, some investors may sell gilts and take a bit of a risk with European bonds or even shares.
3. The Bank of England isn’t buying at the moment
Since Quantitative Easing (QE) began in 2009, the Bank of England has created £375 billion in new money and used it to buy gilts. However, QE is on hold at the moment, so the Bank isn’t making big purchases of gilts. If a big buyer disappears from a market, you’d normally expect prices to fall – all other things being equal.
But I’m not convinced that we’re going to see big falls in gilt prices this year.
One of the biggest drivers of gilt prices has been gloom about the economic prospects for the UK. We all know that the Bank of England’s base rate is very low at 0.5%, and if you think that the rate will persist at that level for years to come, a 2.08% return on gilts doesn’t look so crazy after all.
I can’t see any sign of a sustained economic recovery so the base rate will probably stay at 0.5% for at least another year, probably longer. And remember our sluggish economy isn’t the only reason the base rate is so low. The Bank of England is also trying to make life easy for our troubled commercial banks. That will continue for a while yet.
And the other point is that there is still a significant overseas demand for gilts. In fact, overseas investors bought £15.4 billion more bonds than they sold in December. That’s the highest figure for net purchases since November 2011 and the third highest since 1982.
Now you might say there’s a risk that the markets will lose confidence in the UK government’s ability to repay its debt. And it’s true, if bondholders fear they won’t get their capital back when bonds mature, they’ll sell now regardless of the economic outlook.
But the reality is that the risk of a UK government default is minuscule. As the UK has control of its currency, it can always create more money if necessary, and we can also benefit from a potential devaluation if necessary.
To be clear, a modest fall in prices is possible, and I’m certainly not going to buy any gilts at current prices. I’m investing for the long-term and I need to make more than 2% a year if I’m going to build a sizeable investment pot for my retirement.
But I’m suspicious of the conventional wisdom that a big fall will happen this year. I can’t really see what could trigger a big fall, and I think that a weak economy, a low base rate, and continuing overseas demand will put a floor below prices.
So if I’m right, what does it mean for ordinary folk?
Well, it’s bad news if you’re planning to buy an annuity anytime soon. Low gilt yields lead to poor incomes from annuities.
It’s also a problem for the trustees of old-fashioned final salary pension schemes. For technical reasons, if gilt yields are low, a pension fund’s deficit increases. This will encourage employers to curtail any remaining final salary schemes.
However, high gilt prices aren’t bad for everyone. You might own some gilts yourself or have money in a fund that is wholly or partly invested in gilts. If you’re in that boat, I don’t think 2013 is going to be a particularly bad year for you.
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