Investors that have shied away from government bonds over the last 20 years have missed out on excellent returns but there is still more room left to run, according to Allianz’s Mike Riddell. 
The manager of the £1.3bn Allianz Gilt Yield fund said gilts look “on the cheap side” compared to recent levels despite concerns about valuations and potential interest rate hikes.
Investors have hated investing in fixed income over the last 20 years, Riddell said, favouring corporate bonds over government debt when they have made an allocation to the asset class.
“What we’ve found is that people generally started piling out of gilts in the late 1990s and started buying corporate bonds, and that has just kept going,” Riddell (pictured) said.
“People hate fixed income and where they do own it they have the most high yielding, short-duration things they can find because everyone wants yields,” he said.
“Everyone has been completely obsessed with the idea for the last eight years that interest rates are going up and that they are going to go up quickly.”
As such, he said that the market has viewed anyone holding longer-duration government bonds as “going to get killed”.
“The vast majority of our clients have the same view,” he said. “Where they might occasionally own government bonds [it is] because they have to, as it is 40 per cent of their benchmark. Even then they will be really underweight.
“Almost without exception everyone hates government bonds and that has been one of the worst investment views of the last eight years because they have just kept rallying but as they keep rallying people’s [underweight] conviction just seems to get stronger and stronger.”
Gilt yields have fallen by 71.52 per cent over the last decade as prices have risen and interest rates across have fallen, resulting in strong total returns for gilt investors.
Performance of index over 10yrs
Source: FE Analytics
In the post-financial crisis world, gilt investing has changed with yields falling to new lows and yet to recover to levels seen in the previous decade. However, investors have not caught up.
“I’ve consistently thought that government bonds were not bad value at all because in 2008 something changed,” Riddell said.
“We went into this deleveraging world of low growth and that meant lower interest rates and therefore lower government bond yields.”
This, he noted, was coupled with factors such as low inflation, which has been partly fuelled by a lack of wage growth.
Yet investors continued to forecast higher inflation and wage growth following the financial crisis, which should, in turn, have led to rising interest rates.
“People through 2009-2012 were expecting the Bank of England to be hiking interest rates and quite aggressively; I remember in 2010 the market was pricing in three rate hikes that year,” Riddell said.
“As it happened there were none and you saw this pretty much every year and they never did and actually post-Brexit they cut rates. So it was the complete opposite of what everyone thought.”
More recently, however, people have come to realise that wage growth is not coming through regardless of the unemployment rate leading to reluctant demand for the asset class, he noted, creating pricing anomalies.
Performance of index since EU referendum
Source: FE Analytics
Since the UK voted to leave the EU in June last year, government bond yields have shifted from as low as 0.5 per cent to as high as 1.5 per cent.
“We had a really big rally and the 10-year gilt yield actually reached 0.5 per cent at one point. [At the time] I did say that it had gone too far and was crazy because the market was pricing in no rate hikes for 10 years,” Riddell noted.
A similar level was reached in June this year, with yields falling on the back of uninspiring UK economic data in the first half of 2017.
“You were getting negative real income growth effectively, so the inflation rate was running ahead of wage growth, which meant that the consumer was in big trouble and the consumer has been the only thing driving the UK economy over the last 12 months,” the manager said.
This persisted over the summer but since then there has been a big sell-off in government bonds as central banks globally have broached the idea of raising interest rates.
“What’s happened very recently in the UK is we’ve now got to the point where I think bonds are looking interesting again,” Riddell said.
“Most people probably still hate government bonds, particularly now they are talking about rate hikes, but the market has sold off again quite aggressively in the UK where the 10-year gilt yield is now getting to 1.4 per cent yield. So the market is essentially pricing in a load of rate hikes again.”
Indeed, in the short term, the market is almost fully pricing in a rate hike for November and is actually fully pricing in another rate hike by August next year, he added.
However, for bonds to really sell off further it would require the Bank to hike more aggressively than the market is pricing in, something Riddell thinks unlikely.
“I’m looking at this and thinking 'yes, they have clearly signalled that they are serious about hiking interest rates in the very near term' and it does feel like that is deliberately communicated to the market that they are almost certainly going to hike in November.
“But then the question is do they keep going after that? And that is where I start to think that I’m not sure they do.”
This, he said, is because the Bank is making two assumptions. One that wage growth comes through and the other is that Brexit will not be too messy.
“You could argue that these assumptions have issues so if you believe that the Bank won’t raise rates, particularly in November but then maybe again in August, then you could make the case that gilts right now are good value,” he said.
As such, in the Allianz Gilt Yield portfolio, which has outperformed its benchmark 11 months in a row, the manager has put on a tentatively bullish position having been really quite bearish for the last two months.
“We believe that gilts are looking at least fair value and actually a little bit on the cheap side since we think the whole series of rate hikes being priced in by markets are unlikely to come about,” he explained.
Performance of fund vs sector and benchmark since manager start
Source: FE Analytics
Riddell’s fund has been a top quartile performer over the last year, though it has lost 2 per cent during this time, and since he took over in 2015 has returned 9.15 per cent to investors.
The fund has a yield of 1.38 per cent and a clean ongoing charges figure (OCF) of 0.53 per cent.
This is the first of a two-part series exploring why investors are wrong to shun gilts. In an upcoming article FE Trustnet will also consider the case for gilts from a political and market correction perspective.