Remarkable jump in duration risk for index-linked gilts post-Brexit

12th September 2016

Government bond yields have seen a “remarkable” increase in duration risk since the Brexit vote, which brings greater risks, Kames Capital’s James Lynch has said.

Lynch, the co-manager of the Kames Absolute Return Bond Constrained Fund, said the rally seen in index-linked government bonds post-Brexit – particularly at the long end of the curve – had delivered some very strong returns.

He highlighted that year-to-date returns for those bonds with over 25 years to maturity had come in at an average of 45%.

“What is remarkable has been the increase in duration attached to the issuance. As the government bond markets have rallied, the very long end (ultra) part of the linker curve has seen some staggering year to date returns, and this has been down more to the duration aspect of the product rather than the inflation protection premium.”

UK government bonds have seen stronger returns than government debt from other nations, such as the US, because of the extensive demand for longer-dated securities from buyers such as pension funds and insurers. These organisations need to match long-term funding requirements with liabilities and use longer-dated gilts to help achieve this.

The move means the UK’s Debt Management Office (DMO) can issue fewer bonds to achieve the same level of funding.

For example, Lynch said in February the DMO sold to the market £2.75bn of the 2065 index-linked bond which raised £4.5bn in cash. He said if the same amount of bonds was sold today it would raise £6.9bn, meaning the DMO could issue £1bn less of the same bond and still raise the same amount of cash.

While prices have soared, as the DMO has been issuing longer and longer on the curve, the new bonds have coupons paying next-to-nothing. When coupled with very long dates to maturity, it means such bonds have very high duration, with the recent rally taking duration on 30-year gilts from 19.25 years to 20.12 years.

Despite such extreme levels, Lynch said duration could be extended even further if new Chancellor Philip Hammond introduces any fiscal easing in the upcoming Budget.

“We are still in a holding pattern waiting for the update from the new Chancellor to see if any fiscal purse strings will be loosened, but if we are to see an increase in supply I would not be surprised to see the index-linked curve continue to grow longer,” he said.




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