UK bond stars debate outlook for gilts in 2012

After a momentous year for government debt, during which it far outstripped the majority of asset classes, managers have moved to take profits from positions in several major debt markets.

Investors have cut exposure to bunds, treasuries and gilts across portfolios in the expectation of a pull back in prices and a rise in yields.

But is 2012 really going to be so different to 2011 for gilts? At the start of this year, the Merrill Lynch Gilt index had a yield of 3.22%, while the European High Yield index paid investors 7.96%.

It looked set to be a year to invest in high yield over gilts given the disparity, and many leading names made such a move.

However, year to date the standout winner has been gilts, delivering a return of 13.5% as yields dropped sharply and prices spiked. Meanwhile the European High Yield index has sold off, with yields rising to around 12% from below 8% at the start of the year as investors took risk of the table.

The high yield index has made a total loss of 3.6% year to date, with the 8% yield investors picked up at the start of the year more than swallowed up by the capital loss.

John Pattullo, manager of the top performing £1.1bn Henderson Strategic Bond fund, is avoiding longer-dated gilts in his fund going into 2012.

While he concedes he made the wrong call on the gilt market in 2011, having already backed high yield over gilts, he said the case for buying into longer-dated gilts now is even harder to justify.

"At the start of the year I would have said put your money into high yield and I would have been wrong, but now we stand with a 2% yield from gilts versus 12% from high yield," he said.

"Therefore one would suggest you should be in high yield next year, although I am not uber bullish."

Pattullo now has 12% in short-dated gilts within his cash position, with nothing in longer-dated gilts.

The remainder of the fund is split between high yield, investment grade and loans, while the duration is just 3.5 years.

Duration risk has also increased for gilt investors, with a duration of 9.9 years on average in the gilt market now. A move up in yields of 1% to more normalised levels would therefore cost holders 9.9% of their capital.

Gilt duration is high compared to other safe havens, such as treasuries. T-bills now have an average duration of 4.5 years.

Ian Spreadbury, manager of the £786m Fidelity Strategic Bond fund, said with the fundamental problem of too much debt in developed economies as yet unsolved, the economic environment of low growth and low inflation should continue in 2012.

However, he is heading into 2012 underweight government bonds in his fund, with just 20.6% of the fund in AAA-rated bonds.

"Government bond yields are probably too low and I am concerned gilts could lose their safe haven status, given the scale of debt in the economy," he said.

"So I am running duration significantly under benchmark."

Christine Johnson, manager of Old Mutual Asset Managers' £523m Corporate Bond fund, agreed that with gilt yields near record lows, there is likely to be only one way for them to go from here.

She urged investors to be cautious of a fall in price which could send yields soaring.

"Are yields going to go up 1% from here? It is a possibility, and it is more likely to go up from here than down, so where we can we have been selling long-dated gilts," she said.

Johnson conceded the Bank of England's quantitative easing programme should help mitigate the risks of such a fall in price, but she warned investors need to manage their duration risk in case yields jump.

"The bond market is very macro driven now and whether you like it or not, you have to be managing duration," she said.

"You do have the MPC buying via QE but if you get a resolution in Europe, confidence could return and there could be no need for the Bank to be buying gilts. Then you could see a rapid correction back to normal levels, with yields moving back to 3.5% on the 10-year note."

However, managers are not wholly convinced gilt yields will soar next year. Nick Gartside, manager of J.P. Morgan's £225m Strategic Bond fund, said 2011 could well be a good road map for 2012, and as such, he is cautious on the outlook for gilts.

"You are likely to get more accommodative policy next year, and more QE, so our sense is gilt yields will remain low," he said.

Gartside has sold the last of his gilts this month, taking profits after the recent run, but he did not foresee investors losing much capital if they stayed in gilts.

"Mathematically, it is a lot harder for them to keep going down, but our sense is they will remain low, and we will not see a massive sell-off," he said.

However Gartside, like peers, is running much more in other assets now.

He has 60% in credit, split between high yield, investment grade and covered bonds, with the balance in government and US mortgages - but crucially with no gilt exposure.

Jim Leaviss, head of retail fixed interest at M&G, is also cautious on gilts, as well as bunds and treasuries, warning they offer "mediocre" value.

"Even with growth well below trend, interest rates on hold (or lower) and central banks buying billions of government bonds, upside looks limited. Sell during rallies, but do not expect a return to pre-crisis yield levels for some time (possibly years) to come," he said.

Leaviss instead favours credit going into 2012, with prices already discounting a recession.