DIY Investor Diary: why I’m ‘all in’ on this volatile gilt
A reader shares the details of his bet on a UK government bond maturing in 2061 that is hinged on the economic outlook of the UK.
10th June 2024 11:02
by Sam Benstead from interactive investor
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Our DIY Investor Diary series is no stranger to punchy portfolio bets – but they are normally centred around shares or funds.
However, one ii customer in their 60s, who wished to remain anonymous, is taking a different approach.
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The retired investor, who is based in the south of England, has put the lion’s share of his portfolio outside his pension – £135,000 – into a UK government bond, known as a gilt.
Gilt holders receive semi-annual coupon payments from the UK government – which all but guarantees its interest payments – and the return of their £100 principal per gilt when the bond matures.
While this may appear an extremely cautious way of investing, the devil is in the detail. Gilts come in all shapes and sizes, with the ones closest to maturing offering very different risk and return profiles to those maturing way out into the future.
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This investor has bought TG61 – a bond maturing in 2061 and issued in 50p annual coupons per £100 bond. It was issued when rates were extremely low, in May 2020, but it now has a yield to maturity, which is the annual total return figure assuming the bond is held to maturity, of 4.25%, according to Tradeweb data. The running (or income) yield, which just accounts for the coupons collected and not capital appreciation of the bond, is around 1.7%.
The characteristics of this bond – low coupon and long maturity date – mean that it has a high duration, or sensitivity to interest rates. Its duration is 29.5 years, which compares with just 3.5 years for a gilt maturing in four years’ time, also with a low coupon.
A 1% change in interest rate typically leads to a change in a bond’s price equal to its duration. So, rates increasing 1% leads to a 29.5% drop in the price of this bond, with the reverse also true if rates fall.
This means that when interest rates rise, TG61 bond will fall more than other gilts, and when interest rates fall, it will rise more.
That duration has been on display recently, with the price of the bond plummeting from £93.50 in late November 2021, to £26.50 just two years later. It now trades at close to £30.
The investor said: “I am attracted to this gilt’s duration. Clearly if you look at gilts as an asset class, they have really underperformed recently. It was due to rates going from an all-time low, so gilt yields were minimal, to where they are today after a spurt of inflation.
“TG61 has fallen the most due to its duration. But what goes up must come down. As rates fall there is every chance that there will be a significant capital appreciation for investors buying at today’s prices. I’ve bought at an average price of £29, with yield to maturities of about 4.5%.”
By his calculations, if the yield on the bond drops to around 3.2%, which he thinks is likely to be a reasonable long-term interest rate for the UK government to borrow at, then that means the price of the bond will have to rise to £42, nearly a 50% capital gain on the £29 he has paid for the bond on average.
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He says that he is willing to wait for the gilt to reprice, which is one of the key advantages he has as a retail investor over a professional investor.
“There is a timing factor here, as rate cuts keep getting pushed back, but the first move from the Bank of England is likely to come soon, so it’s a good position to own now before that happens. It could work out in three months, or nine months or 12 months – I'm happy to wait and collect my coupons.”
For this bond to rally, interest rates have to come down. He says that an inverted yield curve – where short-term yields are unusually greater than longer-term ones – suggests a recession is coming. A recession would lead to interest rate cuts and a big rerating of his TG61 gilt.
“My cunning strategy is the inverted yield curve may imply a recession and equity market crash.
“Data shows that one in four mortgage owners could default on at least one interest payment this year. If that is the case, I can’t imagine any government (or the Bank of England) would keep interest rates high for any longer than is absolutely necessary.
“I also think that inflation is likely to come down further than many think. It takes 18 months for interest rate rises to flush through the system and, according to some observers, we’re only about one-third of the way through that process,” he said.
If he’s right that the gilt rally will happen alongside an equity market sell-off, his plan would be to put his profits from the gilt trade back to work in a cheaper equity market – truly selling high and buying low.
Will interest rates really fall?
But what could upset his plan? One possibility is that a Labour government comes in next month and ramps up spending, which could lead to higher inflation and interest rates.
“That is a risk,” he admits, but he counters that financial markets seem comfortable with a Labour government.
The investor got the first ideas for this trade after Liz Truss was elected prime minister and there was the “mini-budget” that caused gilt markets to collapse.
He realised that government bonds could be extremely volatile and represent good investment opportunities, while also paying investors to wait. He has been a dedicated reader of ii’s fixed-income content ever since.
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“I see this as a tremendous one-off opportunity to benefit from a good yield and a significant capital gain. These opportunities don’t arrive very often,” he said.
Another advantage is that gilts are free from capital gains, meaning that any difference between the buying and selling price of the gilt is not touched by the taxman. The investor has some TG61 in his ISA, but the bulk in his General Investment Account.
In our DIY Investor Diary series, we speak to interactive investor customers to find out how they invest in funds and investment trusts, what their goals and objectives are, current issues and concerns regarding their portfolio, and what they’ve learned along the way. The premise is to try and provide inspiration for other investors, and we would love to hear from more people who would like to be involved. We do not require those featured to be named. If you are interested, please email our collectives editor directly at: kyle.caldwell@ii.co.uk.
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