OMAM's Cowley warns on gilt funds

Old Mutual Asset Managers' bond fund manager Stewart Cowley has warned investors in gilt funds face major headwinds in 2012, after falls in yields to record lows left them with little protection from coupons if prices start to come down.

After a storming run in 2011 which left most gilt prices at or near record highs, Cowley said corresponding falls in yields meant investors were now being paid such a small amount of income it would not compensate them for any price falls, leaving them at risk of an overall loss.

Gilts were one of the best performing asset classes of 2011, with the average return from the IMA UK Gilt sector at 13.08%, according to Morningstar.

This made it the second best sector in 2011, behind index-linked gilts, but after such a run Cowley warned gilts are now a far more risky investment.

Cowley, who runs the top performing OMAM Global Strategic Bond fund, said: "There are a lot of funds out there which can only hold gilts, or are mandated to hold long-dated debt.

"As yields decline, the yield volatility you can tolerate gets smaller because there is less and less coupon income to compensate for it. Having ridden the ride in prices we have now cut our duration to zero in the fund."

Cowley said he cut duration in his fund from eight years to zero at the tail end of last year, warning the risks to capital of owning government debt issued by the UK, US or Germany are now "so high".

"We have rotated 10% of the fund into index-linked bonds in the UK and US, and we are short treasuries, gilts and bunds via futures," he added.

Cowley conceded a further deterioration in the eurozone may drive yields down even further on government debt in the short term. However, he says bond yields have bottomed for now, with 10-year gilts yielding 2.05% currently and 30-year gilts paying just 3.09%.

"When long-term interest rates fall below 2.5%-3% there is every incentive to sell the bonds to central banks engaged in QE and hoard the cash," he said.

"The reason is simple; at low yields, as a portfolio manager, your inclination is to think the next yield movement at these times is up. Rising yields are as much a threat to corporate bonds and equities and so all asset classes now look risky, meaning psychologically you are not inclined to buy anything."

With duration of around 18 years in the 30-year bond market, a climb in yields would have a severe impact on bondholders, wiping out 18% of their capital for every 1% climb in yield.

Cowley said: "When interest rates and bond yields do normalise - as you would expect them to do - then the longer-dated end of the market will be hammered by duration."