Talk of a bubble brewing in the gilt market has investors in a quandry – 1534

21st September 2010

The bond market is currently in a quandary. Gilts are ostensibly the most defensive position for a bond manager, but given that they are paying below inflation in many cases they appear to offer little upside.

Indeed many analysts are talking of a nascent ‘bubble' in this area of the market. But if the economic outlook worsens, as many believe it will, it is difficult to see investors pouring money into the higher yielding end of the market, in spite of more compelling valuations.

How are investors dealing with this dilemma?

Certainly, in the short-term it has done nothing to stem the appetite for bonds, but as this article from Fundstrategy suggests, the smart money is heading for the higher yielding and emerging market debt end of the market. 

Andrew Yeadon, head of multi-manager, at Schroders has a significant overweight in the high yield sector.

He says: "There is better value the further investors move towards high yield and away from gilts. This positioned is premised on the fact that default rates are relatively low and valuations look compelling.

"We are shorting gilts in a controlled fashion at the moment. They look over-valued and ought to move higher. They move to yield 5% any time soon, but when the 10Y gilt hit 2.9%, it was a step too far.

"They are likely to drift higher as chances of a double dip diminish."

A browse around data provider site Trustnet suggests that strategic bond managers – those fixed income investors who can roam their way up and down the credit spectrum as they see fit – are a little more cautious.

The top-performing strategic bond managers over the past year are generally clustering around the B to BBB level, believing that this offers the best risk/reward trade off.

There are plenty of people who go one step further, suggesting that investors should be avoiding fixed income altogether.

Ngata on the Motley Fool for example, says: "Investments in fixed interest securities is, today, crazy. No matter if they are government guaranteed. When inflation forces interest rates sky high, bondholders will be crucified on the cross of their own ignorance."

But is there still an argument for investing in the higher quality end of the bond market? After all, even at the top end of the investment grade market, the spreads over government bonds are at historic highs. It is possible to argue that this is because gilts are yielding historic lows, but investors are still receiving a reasonable income yield relative to base rates.

If interest rates are to stay low for longer, which is most analysts' central scenario, government bonds yields may be historically low, but they could go lower.

This article from Yahoo Finance sees an analyst from RBS predict that pan-European bond yields could go as low as 2%. There is still plenty of structural instability across the global economy that could prompt further risk aversion and a flight to quality assets.

Certainly, many investors are glad that they have hung onto gilts. As TheSkyRacer on Motley Fool says: "Where have all the prophets of doom gone? I thought gilts were sitting on a pile of explosives and an unprecedented fall was a certainty. Actually, my bond portfolio has done rather well lately.

"Ahhh, but there has been a euro crisis since then. Oh well, there you go, that explains it."

While interest rates remain low, the much heralded implosion in the gilt market is relatively unlikely. However, that there will not be a crash or could gain a percent or two doesn't necessarily make a compelling investment case. As ever, it depends on an investor's head for heights.


29 thoughts on “Talk of a bubble brewing in the gilt market has investors in a quandry – 1534”

  1. Mr_kowalski says:

    Hi Shaun– can you comment on this SHIBOR report ? t first glance it seems rather unnerving, but–


    1. Anonymous says:

      Hi Mr.K
      We have seen quite wide swings in Chinese money rates or SHIBOR before which then reverse.It does seem to be more prone to such swings than the UK,US or Europe.So for now I would suggest following this with a metaphorical pinch of salt as we need to see how long it persists.

      However starting mid-afternoon UK time on Wednesday we did see a tightening of short-term money interest rate for the Euro,£ and the US $ as the Greek problems caused some contagion. Just to pick one measure of this the Eurodollar future for September dropped by the equivalent of 0.11% over a day (slightly confusingly a drop in such a future means a rise in interest-rates). So there was a squeeze and we will have to see what happens next as it is happening in the face of expansionary action from the main central banks….

  2. Anonymous says:

    …there is a danger in the privatisation programme that assets are sold off cheap to those who in effect created this crisis.

    Surely this is a raison d’être of the current financial system?

    ..consider the consequences of Goldman Sachs being able to purchase some of Greece”s state assets and making a profit from it. They would then be profiting from a crisis which they helped precipitate…

    Surely this is another raison d’être of the current financial system?

  3. Anonymous says:

    Shaun, regarding this post, I am reminded of the inputs from Vassilis_101 last week. I feel both he and I are in agreement that for the last 30 years there has been NO true leadership in Greece, merely two revolving bunches of self-seeking, venal bureaucrats. Similarly with the EU/ECB; no leadership here, merely to pass the buck (to the Greek public) whilst dithering on the sidelines to save their precious “pride”. “Between a rock and a hard place” is now where the Greek general public finds itself. I hope they have enough pride in their country to DO something concrete after the protests since in themselves protests should be the tip of an iceberg of change.

    1. James says:

      I must protest vehemently about the assertion that the EU has no leadership. Who could wish for a more dynamic and democratically accountable pair than Van Rompuy and Baroness Ashton. These political and economic titans will see us all right, I am sure.

      1. Anonymous says:

        ……and the sun WILL rise tomorrow?

  4. Anonymous says:

    Shaun, what was Merkel and Sarkozy talking about – a Vienna initiative to roll over Greek bonds – are bond holders agreeing to buy new ones on the maturity of the older ones? What do the rating agencies say.

    1. Anonymous says:

      Hi Shire
      In essence yes this was what they were agreeing too. For those that do not understand the Vienna initiative it is where some banks agreed to maintain their exposure to central and eastern Europe in 2009. So its application to Greece would involve those who hold maturing Greek bonds being willing to accept new Greek bonds with a lower coupon or interest-rate.

      So they would in effect maintain their exposure to Greece but they would be holding bonds on worse terms as they would be reducing their interest-rate and increasing the maturity of their holdings at the same time.

      In theory that is all very clear but in practice the inconvenient reality is that as each year goes by as things stand Greece looks more likely to default so why would anyone agree to this? So if anyone does agree it is unlikely to be voluntary and accordingly the ratings agencies will probably rule against it and move from c to d for default…

      Just to add that since I replied to this the ratings agencies have been confirming that they would treat it as a type of default.

  5. Mac says:

    What’s the end game here or perhaps more aptly is there
    one?  If the point of the exercise is for
    Greece to become economically stable and viable under Euro Club rules then that’s
    blatantly not possible now given her debt levels and economic capability. 

    If the point is to herald the Euro as a sound major currency
    then that looks to be under attack by the incompetence of those involved. 

    Looks to be a cosmetic exercise in saving face these days but
    the very actions implemented to that end are only storing up more and more eggs
    which will be thrown at some time. 

    It would be nice to think that at some point in the future
    we could expect sound capable leadership and that leadership would insist on retribution
    for past ‘indiscretions’!   

  6. Clare says:

    I understand the problem but not being good at economics I am confused as to the solution (if there is one). I can see it would help if politicians would stop playing politics with the issue but setting that aside can anyone suggest the best way forward?

    Is default now merely a matter of time? How will this impact on the UK?


    1. Mr_kowalski says:

      I’ll give this one a try. In short, Greece is WAAAYYY over their heads in debt and the private markets have stopped loaning money to them. So the EU and others came in and loaned Greece more money, but mandated that they institute some budget cuts and reforms. Greece has done some of these, and it has resulted in a serious mini-Depression there as unemployment has skyrocketed. One other effect of this has been that Greece’s economy is actually shrinking, thus reducing their tax revenues– and so they need to borrow even more because of this. But Greece has not implemented all of the demanded changes and they have not met their budget targets as set out by these EU/IMF loan agreements. Greece will need even more loans than they originally anticipated. But do you really solve a problem of debt with more of it ?  

      A solution ? In short, when someone cannot pay their debts, they will not pay their debts. The answer is to lessen their debt by having their creditors take losses on their loans– upwards of 65%. The problem with this is that many of these creditors can’t take that kind of hit and survive– the ECB possibly among them. Most of this debt is to Greek banks, investors and pension funds– the Greek banks would absolutely not survive this, and would in turn default on their loans. The answer here is for these foreign banks and governments to prepare themselves for this “haircut” and just do it. It’d be very painful for both bankers and the Greek people, but it would at least be organized and there would be hope for the future. 

      This will never happen. What we’ll see is more of the same– more loans, more austerity, more unemployment. Extend and Pretend is The Plan. One day soon enough the people of Greece will have enough of this and storm their Parliament is my guess– and when this happens and Greece defaults on every single cent of debt, it has the possibility of taking down the European banking system. 

    2. Anonymous says:

      Hi Clare
      Mr.K has given you a fairly comprehensive reply. I will just add that the effect on the UK is hard to predict precisely because we do not know either what will happen or when it will happen and we are in my “expect the unexpected” area.

      For first order effects we should only be lightly affected as the amount we trade with Greece is relatively low but with the inter-linking between banks the second-order effects are hard to quantify.

      The real problem is the fact that it would be likely to spread. In my opinion if anyone should cut their banking sector adrift it should be Ireland and we have much more links there..

  7. Sovjohn says:


    Ioannis M here, for those of me who don’t remember my nickname :)

    This past week has been remarkable (politically) in Greece.

    First, there was an accumulation of messages which indicated that as many as 10+ MP’s of PASOK would resign, rather than vote “Yes” to the Mid-Term austerity framework that runs up to 2015.

    Then, 3 of them actually resigned. Lianis, chose to declare himself independent (thus PASOK loses his MP seat / he is no longer a PASOK MP), and then, Floridis & Nasiokas flat-out resigned (and their MP seats are occupied by other PASOK MP’s, the “next in line” for each constituency).

    Before all that happened, we had an unsuccessful attempt for PASOK & New Democracy to negotiate a government of national unity. Each party gives their own story on how events unfolded, but generally speaking, Papandreou did say that he was willing to resign as PM and appoint a third-party PM, Samaras did try to take advantage politically of this situation and did spell some terms that were hard to swallow from PASOK (such as this government’s duration being ~6 months, and others), Papandreou did indeed face an outrage within his own party, and rejected the terms.

    This little feast was described as a “farce” from the majority of the press and commentators, with each major political party trying to pin the blame on the other.

    Then, all hell broke loose :) – Papandreou was supposedly facing a “mutiny” inside his party / government, ministers started supporting him, MP’s started accusing the government (PM & Ministers), blah blah blah blah.

    In the end, we got to this very simple point:

    Venizelos, Papandreou’s former opponent in the PASOK chairman elections, was appointed “vice-god” of the administration. Not only a Minister of Finance, but also a government vice-president.

    I suspect that Papandreou said to him “If you disagree so much, instead of bringing the government down, fix it yourself!”. Papandreou does have the tendency of over-representing Greece abroad, and “supervising” things inside the country, instead of being actively involved in day-to-day matters. He has a rather good image abroad, of course, certainly better than the last Greek PM.

    Anyway, the majority of the people believe that this government, even reshuffled, will not hold for long. Many predict early elections in autumn, supposing everything goes OK with the ratification of the Troika measures in late June, which are certain to face MUCH public protest regardless.

    What happens in autumn? Great question, which I can’t answer. All I know is that Venizelos has the reputation of a much better negotiator / speaker than Papaconstantinou had. I don’t know how much this will, or will not, help the country at this point.

    The thing is that, were I in the EU/IMF/ECB, I would do my best to lighten the YEARLY load of debt on the country. Restructuring? “Haircut”? Whatever it took. I would also provide capital for growth and development, ensuring that my money would probably be sooner paid back.

    Me. Juncker did state recently a good idea, the EU financing 100% of major projects that were “under way” in Greece, with Greece providing its own (40% I think?) share later on. Right now, the Budget’s “Funds for Public Investment” are the first ones which are cut down whenever the government can’t cut any other expenses. And I somehow think that, if anything, this budget should be increased, not decreased, if Greece is ever to see the light of day again.

    Of course, the political bickering taking place in EU doesn’t help – But, well, youth unemployment in Greece reached 42%, general unemployment 16.2%, and this is not the end of it – Not every unemployed is officially registered to the unemployment office. Some are not even eligible to be registered, such as shopkeepers who shut their shops down. And believe me, there are many thousands of closed shops in Greece, in all areas.

    How much lower do things have to go in order to take some “brave decisions”? 2020? I doubt the country will exist by then!

    1. James says:

      Great to hear a Greek perspective. Tell me, are both Papandreou and venizelos related to the people running Greece in the 30s and 40s?

      1. Sovjohn says:

        Papandreou comes from the family of Papandreou, with his grandfather being PM in the 60’s if I remember correctly, and his father in the 80’s-90’s.

        Venizelos is related to Venizelos of the 10’s-20’s, but is more of a “distant relative”, i.e. not a grand-child of the man himself.

        Generally speaking, though, the following political families have indeed run Greece in one way or another in the last 40-50 years:

        And couple of others.

    2. Sovjohn says:

      I read a rather indicative article of what’s going on in Athens (and in Greece in general) at the Guardian before a while. It’s worth having a look, and combine what it says in there with what I described earlier on in this blog.

  8. Anonymous says:

    Meanwhile, let’s not forget the USA.
    Having added nearly 30 million to its population over the 10 years, the US employs 6-7 million people less than in 2005. The implications for the operating costs of this system, from Social Security to Defense Spending are obvious. Thus, it’s a failure of analysis–an inability to comprehend scale–that leads people to conclude good news, or even bad news, from the month to month data.

    1. DaveB says:

       44 million out of a population of 300 million in poverty, if the food stamps issuance is a fair measurement…

    2. Anonymous says:

      Hi Kit
      The issue of the way that countries are treated relatively at this time does trouble me. I like to analyse things with logic but it is plain that logic breaks down at certain points.I am afraid that whilst we like to think of ourselves as rational we also have irrational elements.

      So if we compare ten-year govt bond yields the US was 2.9% today and Greece 17+%. Greece’s national debt is much higher as a percentage of her productive capacity and the US has her own currency and maybe gets some support from it being the worlds reserve currency ( I think this matters a bit but am not someone who thinks that it is a major factor). But is Greece really 6 times worse?

      I am afraid that as human beings our ability to juge risk is nothing like the bell shaped curve of a normal distribution and accordingly the way we behave will favour some circumstances over others.

      So pulling it all together there is some ostrich like behaviour with regard to America’s circumstances but also I feel that were she to start to weaken the markets would punish her very quickly. What will or rather may be the tipping point we can only speculate at…

      1. Rob says:

        Hello Mr Richards,
        Firstly may I congratulate you on your excellent blog. I picked up your link (last year) from another blog after reading your well reasoned economic reply and I read your reports daily.Your articles, information, jargon free and logical analysis are a breath of fresh air and the majority of your faithful and knowledgeable commentators also provide informative points of view but enough of the plaudits…Our foremost economic genius Dr Gordon Brown made it his priority to inform us that it ‘started in America’, I would agree with him to some extent though not with any other of his ramblings.At the start of the financial crisis I wrote a comment on the Jeff Randall blog stating that unless ALL financial institutions/governments in ALL countries involved ‘fess-up’ to their real toxic debt liabilities there would be no solution to the problem. Honesty with the taxpayers around the world (financier of last resort) should have been their priority and not obfuscation, the truth will out, the catastrophic disaster in Japan and its government’s propaganda being another case in point.Why can’t they tell us the truth?Greece’s problems (as you and many here have said) were inherent from/before their entry into the Euro and their demise would now appear to be inevitable. Ireland and Portugal were to follow in fairly quick succession (after much denial) with the next target for the profit hunting wolves, the fourth largest Euro economy, Spain.However very little press (over the last two years) has been given to the financial and economic position of the third largest Euro economy, Italy, why would this be? Spain and Italy, a bridge to far me thinks.. The financial exposure and inter-linking of Euro zone economies (and latterly America’s) is finally being exposed to the taxpayer who are now beginning to understand that the house of cards could fall and where the buck will stop. The politicians in this corrupt EU organisation (and politicians world wide if the truth be known) have only themselves to blame though their future’s will be secure the taxpayer’s will not.It started in America… may well end up back there!      

        1. Anonymous says:

          Hi Rob
          Welcome to my blog and thank you for the compliments.

          As to your points it is one of my themes that the current strategy of “kicking the can down the road” leads to zombie banks and hence little or no improvement. It would be much better to tak actual action which in Greece would have invoved a debt restructuring in the spring of last year for which I argued then.

          As to Italy’s position I feel that so far it has been able to produce official numbers which show that whilst it has a high national debt to economic output percentage that it has got its fiscal deficit under some control. However each country which has come under real scrutiny so far has had to declare some form of misrepresentation be it actual or implied. So until the heat is on we will not know the truth one way or the other I think. Before then I expect spain to come under pressure as the problems wwith her cajas and her housing market are now internationally known…

          As I replied to Kit yesterday sometimes things are just do not seem logical and there is no reason why Italy is not being looked at more. To use my theme of songs “Thats just the way it is”

  9. Anonymous says:

    Is it not possible to ask Greece to leave the Eurozone?   And let the havoc fall on the banks who are basically responsible for the mess.   Governments in France ( particularly) and Germany could then only guarantee genuine savers monies and let investors take the default.  It would have an additional benefit in that the minds of other states would be focused in not lying or massaging their data.   Surely the moral hazard occassioned by bailing out Greece could destroy the Euro.
    I have,up to the moment, always been a supporter of the Euro and the EU, but I think the politicians from each member state are doing a sterling job in wrecking the concept, in that they each regard the Union as a fat cow to be milked at every turn.   Well, the cow is sick and needs a bit of care;  there is no vet in sight.

  10. Dreverts says:

    In the crucial June 30 Greek vote for the reform package, dies anyone know whether a simple majority or 60% majority is required?

    1. Sovjohn says:

      The thought of a 60% (180/300) majority had been considered multiple times, since this would indicate some sort of “consensus” from the opposition (considering the ruling party is at 155 or so MP’s if I remember correctly).

      But yeah, this is scrapped as a thought. Making 155 will be more than satisfying to the government, as things stand.

      It’ll be interesting to see how that vote will go…hm.

  11. Anonymous says:

    Excellent post from Shaun (objective and to the point so different than commentators in UK, Greek, German newspapers). Excellent narrative from Sovjohn of what happened in Greece last week. End game:
    My prediction is that in the end we will have some sort of common fiscal policy and a proper transfer union (with rules though), Because the alternative is disaster and I am sure that the sceptical public in all countries will be persuaded to this if it is told honestly by the politicians that unfortunately the alternative is a total disaster of immense proportions for all.
    X-factor: lack of leadership (of course in Greece and in almost all EU countries and in EU itself) leading to an accident default and a total mayhem.

  12. James says:

    Hi Shaun,
    A belated comment on this amazing Greek saga. According to the Telegraph this morning, one reason for the bail-out having to go ahead is that many investors have CDSs, far in excess of the amount needed to insure the real loans, and that a default would pour money towards these speculators. I am no expert, but it would seem extraordinary to me that the system cannot be allowed to default because noone knows how much money would be lost to people betting on such a default.
    We seem to be a long way from reality in many ways on the Greek situation.

    1. Anonymous says:

      Selling CDSs is like picking up pennies in front of moving steamrollers. I suspect some CDS sellers are underfunded and unable to pay in event of a default. The question is how many CDSs will go unpaid due to seller bankruptcy ?

      1. Anonymous says:

        Hi Guys
        There are issues over credit default swaps but it is also true that their influence is being over-played. They have become something of a bogeyman.

        The last estimates I have seen estimate their value at around 6 billion Euros whereas the Greek debt is more like 340 billion Euros. Now some contracts around them may be geared and there may be other derivative contracts around but looked at like that they are a smaller player than the Telegraph implies.

        I have concentrated on the underlying government bonds more because it is a bigger market. I think others look at cds more because it seems more exciting.As the bond market has got becalmed and volumes have fallen then cds are maybe a bigger influence than they were.

        One of the dangers of a cds is that you are relying on the creditworthiness of those you trade with and yes in the event of default I think some would hit trouble….

  13. Ian_jones says:

    So the ECB will be forced to print their way out just as the UK and US has done. Inflation is the only option as the 1930’s showed what happens otherwise.

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