Benstead on Bonds: historic gilt collapse is a classic ‘blood on the streets’ moment

Sam Benstead looks into the causes and consequences of the chaos in the UK bond market  – and explains why it could be a great investment opportunity.

I’m sure you’ve all heard the famous piece of investment advice to “buy when there is blood on the streets”, as 19th-century banker Nathan Rothschild apparently put it, or “to be greedy when others are fearful and fearful when others are greedy”, attributed to Warren Buffett.

The theory is simple. If you pay bargain prices for companies that are not “value traps”, then there’s the prospect of excellent long-run returns, while overpaying is a sure route to disappointment. 

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But acting on the signs is a different matter entirely as it goes against our natural instincts to follow the herd and extrapolate the near past into the distant future. Having the foresight and patience to keep enough cash to deploy in times of panic is another problem investors normally run into. 

The past month has been one of the biggest UK bond market panics in history, and now some savvy investors are filling their boots as the flash-sale signs appear.

Let’s first put the sell-off into context by looking at the collapse in value of long maturity gilts. TR73, a gilt available to buy by DIY investors, that matures in 2073, and paid a 0.125% coupon when it was issued in February this year, has fallen from £99.50 in March to £39 today, a 61% drop.

TG61, issued in 2020 and paying a 0.5% coupon, maturing in 2061, has fallen from £96 in March this year to £33 today, a 65% drop.

A basket of UK gilts of different maturities has collapsed 30% and a basket of index-linked gilts, which have longer maturity dates and so are more sensitive to interest rates, is down 46%.

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The value destruction in some “safe” UK government bonds, prized by pension funds and the retired for their stable income, has been greater this year than the crash in the bitcoin price (59% drop), Deliveroo (LSE:ROO) shares (59% drop), or high-risk growth investment trust Scottish Mortgage (LSE:SMT)(43%).

Gilt yields, which move inversely to price, have therefore shot up. Investors can now lock in about 4% by lending money to the UK government for 10 years. They can also lock in about 1% above the RPI inflation rate (which includes mortgage payments unlike the CPI measure) by investing in index-linked bonds. 

interactive investor customers have reacted by buying bonds directly, with bond purchases up 700% in the first two weeks of October compared with 2021. Flows into bond funds are also increasing.

Numbers from data group Morningstar this week showed that €8.1 billion (£7 billion) flowed into bonds in the European exchange-traded funds market in the third quarter of the year, compared with €3.2 billion in the second quarter, marking a €5 billion increase. 

This comes as €7.9 billion was withdrawn from the European ETF market in total as investors rushed to raise cash and bet that market falls would continue.

Investment Association (IA) data for August, the latest available, showed that overall investors took £2.6 billion out of funds, which marks the seventh month of outflows this year, but £1 billion flowed into bond funds.

The collapse in the gilt market started when interest rates were forecast to rise substantially to combat stubbornly high inflation, but accelerated when the forrmer chancellor Kwasi Kwarteng unleashed a wave of unfunded tax cuts and spending pledges, which caused bond investors to question the quality of the UK’s debt.

Another issue was that liability-driven pension funds had to sell their long-dated gilts to meet margin calls due to the sharp fall in bond prices.

It’s a complicated area, but in short a “doom loop” was beginning to appear, with plummeting gilt prices causing pension funds to sell more gilts, and therefore sending prices lower still. The Bank of England was forced to step in and backstop the market.

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This gave investors their opening to begin buying gilts at rock-bottom prices, especially when compared with bonds issued by normally riskier countries, such as Greece and Italy.

One of those was Peter Spiller, the veteran manager of Capital Gearing (LSE:CGT) investment trust, which has compounded at 15% annually since during his 40-year tenure.

His colleague Alastair Laing told me last week that they were excited about 10-year index-linked gilts now offering 2% returns above CPI inflation, or about 1% above RPI inflation.

Laing noted that investors could have got 4% above the RPI rate in the 1980s, but given that we could have above average inflation for some time yet, he said locking in a return above that with no credit risk was an excellent opportunity, especially as the bonds can be held inside an ISA or SIPP. 

Now, with Jeremy Hunt the new chancellor, the outlook for the gilt market is much more positive. Hunt has reversed nearly all of Kwarteng’s mini-budget, and with Liz Truss at risk of being ousted, a more financially conservative prime minister could also be in place soon.

These moves have been celebrated by bond investors, with the yield on the 10-year gilt now below 4%, giving investors who bought gilts during the peak of the crisis about a 5% return if they had purchased an ETF that owned a basket of gilts.

Schroders, the fund group, calculates that the policy reversals announced so far could reduce government borrowing by just under £100 billion or 4% of GDP by 2026-27.

This means the Bank of England is under less pressure to raise interest rates by as much due to a lower inflation risk, with markets now pricing in a peak rate of 4.75% next year rather than 5.5% previously. 

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But Schroders thinks that the Bank could raise rates by less than markets expect, and its lending rate could top out at 4.5%, which if true would be a boost for bond markets.

Another market bull is Stephen Snowden, head of fixed income at Artemis. He reckons that the economy is about to go into a tough place, with interest rate rises starting to appear in higher mortgage and rental costs, which will then lead to a “nasty recession which will undermine many of the drivers of inflation”.

This will lead to falling inflation and interest rates, which would be great for bonds and reward anyone who locked in a high yield today. Snowden says that we have entered one of those phases where “buying bonds again is - if not quite yet - close to becoming a no-brainer decision”.

Of course, inflation could keep rising and rates may have to go above 5% – and stay there – all of which would spell bad news for bonds.

But a lot of the risk has come out of the market due to a change in chancellor and yields rising to inflation-beating levels for investors willing to hold on to bonds for more than a year.

The peak of the panic may be over with a change in economic policy, but bond markets still look good value, and investors are beginning to vote with their wallets.