Are Gilts Safe?

As the UK Treasury look to auction a new 2061 Gilt issue, we examine the risk and return attributes for real investors

The UK Treasury will syndicate a 2061 Gilt on Tuesday 19th May, the coupon will be 0.5%. This is a very attractive interest rate for the government to lock in 40 year money.  In fact due to the shape of the UK yield curve, it is cheaper to borrow for 40 years than 30 years.  According to market commentators this issue will be favourably received by institutional investors given the lack of issuance at this maturity date.  Its low coupon means that this will be one of the longest duration Gilts and will meet the need of pension funds and insurance companies who need duration to match their liabilities. In any case the issue is bound to be a success because there is a guaranteed buyer in the secondary market - the Bank of England.

Whilst this looks like a great deal for the Government, ‘ordinary' investors might consider whether this is an attractive investment.  If we invest £100 for 41 years at an interest rate of 0.5%, we end up with £122.69 in 2061 - a total return of 22.7%.  However, what will that be in today's money? There are various estimates of future inflation.  The UK breakeven inflation rate for the next 50 years is actually 2.59% but we might conclude that this is a distorted figure.  We could use the Bank of England's 2% target for CPI.  Even if we assume that inflation averages just 1% to 2061, your £100 investment will be worth about £81.  If we use 2% inflation the real value of your £100 becomes about £54 and if we use 2.59%, the payout is just £42. 

But that is not the only problem.  The very high duration of this Gilt means that the price will be incredibly sensitive to any changes in the yield that the market is prepared to buy it at in the secondary market.  Remember the total nominal return over the next 41 years is about 23%.  If the yield in the market for 40 year Gilts rose from 0.5% to 1.0%, the price of this bond would fall from £100 to £83 - a loss of 17% which would wipe out almost all of today's prospective return.  In that scenario, it could be a very long wait to get your capital back.  How likely is it that the yield could move that much? We don't need to look back very far to see an example of that kind of shift in the market.  If we just look at the 30 year benchmark Gilt, it fell 18% between 9th and 18th March. Admittedly it rose by 20% to 8th May but the point is that investors are buying a huge amount of volatility in exchange for a very low nominal return which is highly likely to destroy value in real terms.

The UK government should take full advantage of these yields to fund much needed fiscal spending to help the economy out of this crisis but investors should be wary of being on the other side of the trade. Gilts are not safe.