Ten-year UK gilts could go negative, but they are still attractive – Aegon Asset Management’s Finlayson

Aegon Asset Management (AAM) still considers gilts attractive, even if yields go negative, with government bonds continuing to offer value to investors, according to Colin Finlayson, co-manager of the Aegon Strategic Bond Fund.

The value in fixed income markets is much reduced but it has not all gone, says Finlayson, who believes that although some government bonds, in the UK in particular, could turn negative, they should still be considered as desirable assets in the current climate.

 
“While negative yields may cause some to abandon Government bonds, the reality is that investors hold Government bonds for a variety of reasons. The lessons from Europe have shown that negative yields have not reduced the attraction of Government bonds in times of stress and where liquidity is valued,” says Finlayson.
 
“The fact that, if held to maturity, you are taking a small total return loss, is a secondary concern in a flight to quality that sees risky assets plummet. In that case, the further fall in yields can actually add value by locking in gains and not holding to maturity.
 
“The other factor is liquidity. There are few, if any, assets that offer the degree of consistent liquidity you get from US Treasuries, UK Gilts or German Bunds. The importance of this cannot be underestimated. When the going gets tough, the tough need liquidity – maybe the negative yield on these assets is the price you have to pay for that.”
 
On the likelihood of yields turning negative, the fixed income manager thinks this is more likely in the UK than the US.
 
“The question of whether bond yields in the US or UK will trade with a negative yield is in large part a function of whether the market believes their respective central banks will cut official interest rates below the zero bound. I believe this is more likely in the UK than the US,” he says.
 
“The UK is facing the challenges of the Covid-19 crisis, with a huge contraction in growth and, thus far, a sluggish recovery. That alone will likely require the Bank of England to add further stimulus.
 
“With the risks of a no-deal Brexit also rising, they may have to consider any-and-all tools at their disposal, including negative interest rates. Under that scenario, it is very likely 10-year gilts could trade with a negative yield.”
 
The situation is less extreme in the US at present, with Finlayson not expecting such a move in US Treasuries.
 
“The US Federal Reserve has been firmer in its opposition to negative interest rates. For the Fed, an increase or broadening of their asset purchase programs would be preferred,” he says.
 
Finlayson adds investors are again turning to the bond market as equities have become more volatile in recent times, but that those investors will be looking at value against the market (alpha) more than relative risk (beta).
 
“With investors still demanding yield, they are turning again to the bond market, as alternative sources of income such as equities, have become less certain. The difference now is that the value will come more from alpha rather than beta,” he says.
 
“When you overlay this with a macroeconomic backdrop dominated by weak growth and a lack of inflationary pressures – both of which will help keep central banks on hold for some time – the downside for fixed income assets looks limited.”
 
In terms of positioning Finlayson, manager of the Aegon Strategic Bond Fund, says maintaining exposure to government bonds makes sense now.
 
“Within government bonds we have maintained a higher than average level of duration and favour the US, UK, Australia and New Zealand over core European markets, Canada and Japan,” he says.
 
“At the same time, we have reduced our allocation to inflation-linked bonds after a strong rebound.  We continue to favour corporate bonds, even as our overall investment-grade allocation has been trimmed back.
 
“We still see value in financials over non-financials with a bias to reduce UK banking exposure in favour of European banks as Brexit risk re-emerges.
 
“Meanwhile, the high-yield market rally has been impressive but the spread differential between high-yield and investment-grade bonds is still wide compared to historical levels. While this will help offer support to the asset class, the focus is increasingly on stock selection, and caution is required as many bonds that look ‘cheap’ are cheap for a reason.”
 

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