Portfolio Adviser • Portfolio Adviser Magazine December 2021 • Fund selector

Gilts and index-linked bonds don’t o er much opportunity for additional returns, but with the spectre of inflation looming they are sectors worthy of further investigation

While a conventional government bond will pay a fixed principal and coupon, and is therefore subject to erosion in real terms, index-linked government bonds can provide protection against inflation, since the principal and interest payments on the bonds will rise with the inflation rate to compensate an investor.

The IA UK Index-Linked Gilts sector is home to only 14 funds, six of which are passive. The IA UK Gilts sector is larger, at 39 funds in total, including 19 passive funds. Historically, these markets are relatively efficient, making it difficult for active managers to produce returns in excess of the benchmark. That said, opportunities for small additional returns do present themselves both in the primary and secondary market. However, once fees have been deducted, any outperformance is likely to be slim.

Within the UK index-linked gilts sector, there is limited difference among active funds. This is exemplified in the performance differentials between the top and bottom decile funds which, over the longer term, has been about 1% annualised. The reason for this is all funds within the sector have an all-maturities mandate, meaning they will have similar risk exposures to both duration and inflation breakevens.

In the UK gilts sector, there is more variety in the underlying strategies. This is because from a maturity perspective while most funds are all-maturities, some funds target the shorter end of the market and some the longer end.

To be included in these sectors, funds must invest at least 95% of their assets in sterling-denominated – or hedged back to sterling – government-backed securities. These must be index-linked securities in the UK index-linked sector. They must also have a rating the same or higher than that of the UK, with at least 80% invested in UK gilts or index-linked gilts.

As of the end of September, the assets under management of the UK gilts sector stood at £26.3bn and £7.4bn for the UK index-linked category, with net one-year inflows of 5.2% and 7.2%, respectively, showing the sectors continue to remain relevant for the UK market.

Since the rollout of vaccines and the reopening of economies across the globe, UK government bond yields have generally been on an upward trajectory – from ultra-low levels – driven by inflation expectations that have continued to climb higher as demand recovers rapidly and supply chains remain disrupted.

At the start of the fourth quarter of 2020, the yield on the nominal 10-year UK government bond stood at around 0.2%, the equivalent real yield (the yield on the 10-year inflation-linked government bond) was -2.8%.

The breakeven inflation rate, which is the wedge between these two figures representing the market implied inflation rate, was therefore about 3.1%. As of the 18 November 2021, nominal yields, real yields and the breakeven inflation rate were 0.9%, -3.2%, and 4.1%, respectively.

While nominal yields did fall through the summer months, in response to a combination of growth concerns, the delta variant and technical factors, they then proceeded back onto an upward trend as central banks globally began to signal and implement a more hawkish monetary policy.

In the UK, despite the Bank of England deciding to keep rates at 0.1% in November, as of mid-November markets are pricing in 1% worth of rate hikes by the end of 2023.

In recent months, 10-year UK breakevens have reached heights not seen for more than two decades, while real yields have fallen deeper into negative territory. There are a number of macroeconomic factors here, such as the global reflation narrative, rising energy costs and labour shortages.

Technical dynamics have also been a factor, as there has been a squeeze on the supply of index-linked gilts issued by the Debt Management Office, which has put downward pressure on real yields.

As a consequence of these significant moves in both government bond yields and inflation expectations, the past 12 months has been volatile for the IA UK Gilt and IA UK Index-Linked Gilts sectors.

From the end of September 2020 to the end of March 2021, the UK gilt and UK index-linked sectors were down 7.3% and 6.4%, respectively. Negative returns over the period were to be expected in an environment of rising government bond yields.

These losses were mostly driven by interest rate risk (duration), which is a key driver of returns of funds in these sectors. A typical all-maturities UK index-linked index has around 21 years’ duration, while a typical all-maturities UK conventional gilts index has around 12 years’ duration.

The exposure to breakevens in inflation- linked bonds cushioned the performance of the inflation-linked assets due to the increase in inflation expectations.

Within the gilts sector, the funds that focus on the 0-5 year part of the market are significantly less exposed to duration risk, and hence are likely to outperform their all-maturities counterparts through periods of rising interest rates, as was the case through the fourth quarter of 2020 and the first quarter of 2021.

Since the end of March 2021 to the end of October 2021, there has been a much greater degree of discrepancy in the performance of the two sectors due to the squeeze higher in the market implied inflation rate. The UK gilts sector is up 1.9% for the period and the index-linked gilts market is up 12.2%.

FUNDS TO WATCH 3-YR PERFORMANCE

● Lead manager of the Allianz Index Linked Gilt Fund Mike Riddell (pictured) has demonstrated during his career that he has the investment ability and nous to add value for investors. Supported by the wider fixed-income resources at Allianz, the team behind this fund employs a highly active and tactical approach to macro investing. This has delivered solid outperformance of the index since launch.

● The managers of the Royal London Index Linked Fund, Paul Rayner and Ben Nicholl, are experienced fixed-income managers and part of a team that adopts a collegiate approach. They have shown an ability to combine macroeconomic assessment with an understanding of the UK index-linked government bond market to navigate various market conditions and have delivered solid relative returns over the long term.

● The ASI Sterling Inflation-Linked Bond Fund is managed by Tom Walker, and this UK inflation-linked government bond fund also has a dedicated inflation team behind it, allowing them to concentrate on the specific issues and idiosyncrasies inherent within the UK inflation market. The process is collaborative in nature, allowing the inflation team to draw on the vast depth of expertise available across the broader business.

FUNDS TO WATCH NEWCOMERS

● The FTF Franklin Templeton UK Gilt Fund primarily invests in UK government bonds but also in supranational and government-related securities. Based in London, the team has broad experience investing in fixed-income markets. The investment team consists of David Zahn (pictured) and Roderick MacPhee, who will aim to achieve a level of overall total return which reflects the underlying UK gilt market.

● The JPM UK Government Bond Fund provides access to a well-resourced and highly experienced team investing in the UK government bond market. Managers Seamus Mac Gorain and Iain Stealey will leverage the wider global rates team at JPM to gain exposure to a diversified source of returns such as duration, curve, cross-market, sector and currency positioning.

● By investing across all maturities of conventional gilts, the managers of the Fidelity Index UK Gilt Fund, Lucette Yvernault and Ilia Chelomianski, aim to track the performance of FTSE Actuaries UK Gilts All Stocks Index. The team use a proprietary portfolio optimiser for an efficient portfolio construction process to ensure reliable and consistent performance outcomes.

FUNDS TO WATCH ASSETS UNDER MANAGEMENT

● The Royal London Short Duration Gilts Fund invests in 0-5 year UK government bonds, and Craig Inches (pictured) and Ben Nicholl are part of the same experienced team as the Royal London Index Linked Fund. The team has demonstrated its ability in the UK government bond market and has an improving track record. Moreover, there are no open-ended passive funds tracking the asset class in this part of the market which has likely contributed to the size of the fund’s assets.

● The two largest funds in the UK gilt sector are open-ended passive funds, both of which are more than twice the size of the largest active fund. This highlights the difficulty of outperforming in this efficient market, and investors have favoured passives. The size of the iShares UK Gilts All Stocks Index, iShares’ commitment to operating passive strategies, the fund’s cost and its good record of tracking the index make this fund a desirable passive alternative.

● The Allianz Gilt Yield Fund is managed by the same team that runs the Allianz Index Linked Gilt Fund. Led by Mike Riddell, the team has consistency in outperforming the index with its active and tactical approach. The team aim to construct a portfolio they believe will take advantage of the key macroeconomic trends impacting the UK government bond market.