The benchmark 10-year gilt yield stood at a breezy 1% at the beginning of the year, before the Ukraine crisis proved to be the catalyst for the current inflationary crisis, and a round of interest rate rises that has seen the Bank of England base rate rise from 0.25% to 2.25% in just nine months. The result is the yield on the 10-year gilt now stands at 4%, a level not seen since before the financial crisis, which begs the question whether these government bonds are now an attractive option for investors once again.

The low yields, and high prices, exhibited by gilts in the era of ultra-loose monetary policy, led some to conclude that an investment in gilts represented a ‘return-free risk’. That was a pretty rational assessment, but nonetheless in practice proved misguided, because low interest rates and the QE (quantitative easing) schemes of central banks continued to drive up bond prices.

WHY THERE HAS BEEN A BIG CHANGE IN THE GILT MARKET IN 2022

This year that has totally changed, as monetary policy has sharply changed direction. Gilt prices move in the opposite direction to yields and interest rates, and as a result some longer dated bond funds have fallen in value by 40% or more.

Both the prolonged period of high bond prices following the financial crisis, and the recent sell-off, could be said to be vindications of the old motto that you shouldn’t fight the Fed (US Federal Reserve). In other words, if central banks are moving interest rates up or down, you should follow their lead rather than trying to be clever with a contrarian view. Today the future path of interest rates is still expected to be upwards, with some now even forecasting that UK base rate will hit 6% next year.

Current bond yields should already price in expectations of future interest rate increases to some extent. But this isn’t a static picture, and there are influential geopolitical machinations which could deepen or prolong the inflationary crisis, thereby putting pressure on the Bank of England to raise rates further. There will also be a large supply of gilts coming to the market in the next year, to fund the Government’s energy price freeze and its tax cuts, not to mention the £80 billion of gilts the Bank of England is planning to shed from its balance sheet as it unwinds QE. All of that will also serve to put downward pressure on gilt prices.

WHY GILTS CAN PERFORM A USEFUL ROLE IN A PORTFOLIO

Gilts will do well though, if there is a dramatic improvement in the inflationary picture, or the Bank of England signals that it is willing to take its foot off the accelerator when it comes to interest rate rises. That doesn’t seem on the cards for the moment, but central banks always have the capacity to surprise market expectations, one way or the other. The global economy is slowing, and at some point the Bank of England will want to stop tightening monetary policy. No-one knows when that will be, but when it happens, that will likely prove a turning point for bond markets.

The big, imponderable question, is what happens to prices in between now and then, and without a crystal ball, there is simply no way of telling.

Gilts can perform a useful role in a portfolio, because they will tend to move in the opposite direction to share prices. So by holding both, you can reduce the volatility of your overall portfolio. Now gilts are yielding that much more, you’re also getting a better return and taking less valuation risk in holding them. The rise in yields is good for income seekers too, who for many years have been priced out of gilts and into other asset classes, because interest rates were so low. The irony though, is that gilt yields still look paltry compared to current rates of inflation, But then, at the moment that applies to returns on all asset classes.

WHY GILTS COULD BE MORE ATTRACTIVE NOW

Gilt prices have fallen so sharply this year that a lot of froth has been blown out of the market. Conservative investors considering investing some of their portfolio in gilts are therefore now doing so at much more reasonable prices than a year ago, though there looks to be scant chance of prices going back to where they were when interest rates were at rock bottom, and inflation was contained. At current yields a modest return can be harvested, even if it is significantly below the rate of inflation, but then again, some cash accounts are now offering similar rates of return, and don’t come with the same price fluctuations as gilts.

If you are interested in investing in gilts you can buy them directly through the UK Debt Management Office if you become a member of its Approved Group of Investors or through some investment platforms. Gilts are also eligible for ISAs.

It may though be more straightforward and cost-efficient to use an ETF (exchange-traded fund) to gain diversified access to gilts, with several UK-listed options shown in the table.

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