February 5, 2010 / 10:16 AM / 9 years ago

Fund firms fight shy of gilts on volatility fears

LONDON, Feb 5 (Reuters) - Fixed income managers are fighting shy of UK government bonds, fearful of volatility ahead of a general election and the market’s capacity to fill the hole left by the Bank of England’s exit from quantitative easing.

Managers like Threadneedle, Schroders (SDR.L) and Sarasin are underweight, short duration, or shorting UK gilts, concerned that as the BoE ceases quantitative easing (QE) and issuance builds, buyers will refuse to play ball.

“The market has moved to a defensive posture,” said Quentin Fitzsimmons, executive director, fixed income, Threadneedle. “If investors go on a buyers’ strike, prices could fall sharply and yields could rise.”

Bond bears argue that yields are artificially low because of QE. “Most of the time if that’s the case you have to normalise to something more average, and in the process you lose money,” said David Rolley, portfolio manager at Loomis Sayles.

Opinion polls indicate the opposition Conservatives will win the general election expected on May 6, but their narrowing lead over the Labour government has worried markets about the possibility of a hung parliament — which could impede the passage of much-needed economic reforms.

With such an unclear policy outlook, any event in the run up to the election that questions the UK’s fiscal trajectory could be problematic for bond markets.

In particular, managers fear being caught out by a sudden flight to quality. This could trigger a short squeeze as underweight bond managers struggle to get back to neutral as bonds are bid up.

“If it’s the consensus view to be bearish then the risk of the market behaving in a way that could confound that view is quite high,” Fitzsimmons warned.

The Bank of England currently holds some 28 percent of all gilts in issuance. Fitzsimmons calculates that with the UK deficit now at 13.5 percent of GDP, the Debt Management Office has to sell 18.75 billion pounds ($29.87 billion) of gilts every month in the market to meet their funding obligations.

Finance Minister Alistair Darling predicted government borrowing this fiscal year would reach a record 178 billion pounds, or 12.6 percent of GDP.

Although insurers and pension funds will provide some structural support, managers question whether commercial banks will buy enough gilts to offset the withdrawal by the Bank of England.

“The risk is that the demand won’t turn up when the supply turns up, so you have a recipe for volatility because the numbers involved are so large,” said Fitzsimmons.


Some managers are also fearful of a rapid rise in inflation. Simon Ward, chief economist at Henderson HGGH.L, argues that imported inflation from overheating emerging markets will surprise on the upside and lead to central banks tightening sooner than the market expects.

This is contested by bond bulls who believe that as long as the UK economy stays weak and unemployment high, inflation can’t get going as there is no excess demand. Getting this call right has implications for serious under- or outperformance.

“There are such strong arguments on both sides of the inflation versus deflation debate, that the risk of being wrong is high,” said Jim Wood-Smith, head of research at Williams de Broe. “And if you are wrong, the downside is crushing.”

Nick Gartside, head of global fixed income at Schroders, currently shorting gilts in his Strategic Bond Fund, believes Western governments have adopted a deliberate policy of inflating their way out of the debt crisis.

This is suggested by the fact that the amount of inflation-linked debt being issued as a proportion of total government debt has fallen in the UK, US and Europe.

For example, in the UK inflation-linked bonds account for 13.6 percent of total gilt issuance in 2009-10, compared with 27.5 percent in 2006-07.

“Western governments have two options to deal with their debt crisis which is to take economic pain or they can inflate their way out of the debt,” said Gartside.

“If you have 4 percent inflation for the next 10 years, that inflates away about a third of your outstanding debt,” he said, citing a recent study by Societe Generale.

For Guy Monson, managing partner at Sarasin & Partners, inflation, a supply glut and the potential for a ratings downgrade provide a cocktail of reasons to be bearish on gilts, but he is not sure the Bank of England will get to determine bond yields, except at the very short end.

He is more interested in what will happen in the 3-10 year market, which will be determined by the return of the bond market vigilante, he suggested.

“These people arbitrate what sort of yields governments can get paper away at. As QE fades away, and government issuance goes up, it will be the market that decides,” he said.

Further out, he sees the potential for a longer bear market for government bonds, suggesting we could be in the early stages of an asset allocation shift.

He believes institutional investors are beginning to question whether the default position of sovereign AAA and AA-rated names should be maintained to the same extent. “It could be the beginning of a material shift if the coupons on some corporate names are safer than UK gilts,” he said. (Editing by Andy Bruce)

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