14 May 2019
Investors are having to come to terms with the return of volatility. After several years of relatively stable conditions, the slide in equities at the end of last year and the subsequent recovery in the first quarter of 2019 were a stark reminder not to become complacent. David Zahn, manager, Franklin UK Gilt Fund, looks at the implications for the gilts market and explains why he believes an active approach to gilts management makes sense now.
We believe investors should continue to expect a degree of volatility as markets unpack the uncertainty surrounding Brexit, global trade spats and pessimistic economic outlooks in certain regions of the world.
If we look back over the last 10 to 15 years, there have been times when bonds and equities were positively correlated.1
Now we’re starting to see that negative correlation coming back.
Against that background, we’d expect growing interest in gilts (UK government bonds), which have traditionally provided steady returns in times of heightened volatility.2
In our view, we’re at the low point of gilt yields in the cycle, in part due to the uncertainty surrounding the Brexit outcome.
We don’t feel there’s much likelihood of yields falling further.
Equally, we don’t expect any imminent increase in interest rates across major developed economies, which could send yields on an upward trajectory.
We don’t expect the European Central Bank (ECB) to begin raising interest rates until at least 2021. Similarly, we think the Bank of England’s Monetary Policy Committee (MPC) is unlikely to raise rates for at least a couple of years until it sees a Brexit resolution. The US Federal Reserve (Fed) has said it’s not going to raise interest rates this year and the Bank of Japan is still implementing quantitative easing (QE).
But the bond market—particularly the longer-dated securities—doesn’t always move just based on central bank activity.
For example, we think gilts yields currently are artificially low, because of the Brexit uncertainty.
Once Brexit is settled, we think fundamentals could reassert themselves. Therefore, we should see yields start to rise once a resolution emerges.
At the same time, if there were to be a growth surprise to the upside, you could see yield curves— the graphical representation of the spread between short- and long-term interest-rate instruments— steepen even before central banks act.
We think it’s important for investors not to think of gilts simply as a separate asset class, but to think how it fits into an entire portfolio. And what does it do for risk-adjusted returns.
We feel that a gilts allocation can contribute to a balanced portfolio composition. Many people have held gilts in their index-based investment products. But in many cases, they haven’t considered that the duration3 of the gilts market has lengthened dramatically.
Longer duration means more sensitivity to interest-rate changes. So, there’s a real chance that by that measure, an index gilt fund is riskier today than it was 10 or 15 years ago.
A passive investment can only follow market turbulence. An active manager strives to use the volatility to an investor’s advantage by actively managing duration.
Gilts have been a very liquid asset so an active manager can move duration in their portfolios (longer or shorter) depending on their analysis of conditions.
Although we don’t expect an interest-rate increase in the United Kingdom in the near future, we do believe it’s important to have the opportunity to move asset allocations and/or the duration of a portfolio without having to make a decision to exit the asset class completely if conditions change.
That generally requires moving away from a passive index approach to an active approach.
Important Information
For Professional Client Use Only. Not for Distribution to Retail Clients.
© Copyright 2019. Franklin Templeton Investments. All rights reserved. This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or an invitation to apply for shares of any of Franklin Templeton Investments’ fund ranges. Nothing in this document should be construed as investment advice. Franklin Templeton Investments has exercised professional care and diligence in the collection of information in this document. However, data from third party sources may have been used in its preparation and Franklin Templeton Investments has not independently verified, validated or audited such data. Opinions expressed are the author’s at the publication date and they are subject to change without prior notice. Given the rapidly changing market environment, Franklin Templeton Investments disclaim responsibility for updating this material. Investments entail risks. The value of investments and any income received from them can go down as well as up, and investors may not get back the full amount invested. Past performance is not an indicator, nor a guarantee of future performance. Currency fluctuations may affect the value of overseas investments. When investing in a fund denominated in a foreign currency, performance may also be affected by currency fluctuations. In emerging markets, the risks can be greater than in developed markets. Any research and analysis contained in this document has been procured by Franklin Templeton Investments for its own purposes and is provided to you only incidentally. Franklin Templeton Investments shall not be liable to any user of this document or to any other person or entity for the inaccuracy of information or any errors or omissions in its contents, regardless of the cause of such inaccuracy, error or omission. For more information about any Franklin Templeton Investments’ fund, UK investors should contact: Franklin Templeton Investments, Telephone: 0800 313 4049, Email: ftisalessupport@franklintempleton.co.uk or write to us at the address below. Alternatively, the information can be downloaded from our website www.franklintempleton.co.uk. Issued by Franklin Templeton Investment Management Limited (FTIML) Registered office: Cannon Place, 78 Cannon Street, London EC4N 6HL. FTIML is authorised and regulated by the Financial Conduct Authority.