Gilts - don't buy them
By
Tim Price Mar 24, 2009
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Gilts are the ultimate safe investment.
Gilts are where UK investors go if they're looking for risk-free returns. So it's little wonder that the carnage of the past year has made them one of the more popular asset classes around.
And the Bank of England's recent decision to jump into the market has sent prices soaring and yields diving. With such a significant buyer around, investors reckon they're on to a sure thing with gilts.
And that's just one reason why I wouldn't touch them with a 10-foot barge pole right now…
Gilt prices have rallied strongly in recent weeks on confirmation of the Bank of England's decision to start quantitative easing (printing money, or QE for short). This process is a little too easy for my tastes. The UK Treasury issues bonds – and the Bank of England buys them straight back. Problem solved!
But there's only so much manipulation a market can bear.
Gilts aren't 'risk free' any more
My friend Patrick Perret-Green at Citigroup has crunched the numbers. The Bank of England has so far declared it will spend up to £150bn of freshly-minted money on buying up various assets. Up to £100bn of that will go on Gilts. The UK's budget deficit for 2009/10 is currently estimated at £150bn (though that could well be optimistic). So if the Bank spends the full £100bn, then it'll be buying roughly two-thirds of the bonds the government needs to issue to fund its spending plans.
Unfortunately, the 2010/11 deficit will be even bigger. And who knows when it'll start to fall? That's a question that the next government, which is unlikely at this rate to be Labour, will have to answer. Even within five years, a budget deficit of 8% would be the largest in British post-war history (at least until the financial crisis began).
So while we have a large short-term buyer of Gilts (the Bank of England), the fact that we'll be in debt for the foreseeable future means that we have an even larger perma-seller of Gilts, in the form of the State.
And something else bothers me about the Gilt market. Gilts are described as offering 'risk-free returns' but right now, I reckon 'return-free risk' is a more accurate description. Our nation is so heavily indebted that any sensible investor would have to be concerned about the safety of lending their money to it.
It's not just the scale of government debt that's worrying. There's the semi-nationalised banking sector to worry about too. Citigroup points out that at the end of 2008, Royal Bank of Scotland alone announced a balance sheet of £2.4 trillion ($3.3 trillion). That of Lloyds TSB was "only" £436bn, that of HBOS £689bn, and Barclays a really sizeable £2 trillion.
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Citigroup ignored Northern Rock, HSBC, Bradford & Bingley, Abbey National and Alliance & Leicester in its calculations. So excluding them, the total balance sheet of major UK banks stands at £5.6 trillion ($7.8 trillion). Nominal GDP in the UK is only £1.4 trillion. So our three major banking institutions have a balance sheet of 400% of UK GDP. The government is implicitly, and in some cases, explicitly supporting them. As Patrick asks: "Do you feel lucky?"
I don't. Appetite for conventional government bonds is currently being driven by a) sustained flight to quality panic and b) 'greater fool' buying in the knowledge that the Bank of England is the buyer of last resort – the 'greater fool'. That doesn't strike me as a sound investment case for any asset.
Corporate bonds are better bets than Gilts
The corporate bond market on the other hand, is much more attractive. The spreads available on investment grade corporate bonds haven't been this generous since the 1930s. In other words, the market is pricing in an outcome as bad as the Great Depression.
I'm not saying that won't happen. There's a great deal of risk attached to junk (higher-yield, but lower quality) bonds. But as long as you stick to investment grade bonds, you should be able to make decent, comparatively safe returns. And on an individual basis, high-quality stocks are looking cheap too – you can find out which ones I like by subscribing to my Price Report newsletter.
But don't buy individual bonds. There's just too much risk in doing that. Invest in a corporate bond with a decent yield and sure, you stand to earn a few extra percent on your money, which is all well and good when deposit rates are close to zero. But if the bond issuer goes bust, you run the risk of losing your entire investment.
Any investment whose upside is a few extra percent (in income and potentially in capital gain on the price of the bond), but whose downside is 100% is just not worth the risk, unless you have a portfolio large enough to accommodate one or for that matter several defaults.
For most of us, that's simply not realistic – which is why I recommend using a corporate bond fund (my current favourite being the M&G Corporate Bond Fund) over picking individual bonds.
• Tim Price is an expert in investing in troubled times, and winner of the Private Asset Managers' Award for Defensive Investment.
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