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The role of government bonds when interest rates are rising

one year ago

If we experience another disruptive event like the financial crisis of 2008 your portfolio will need an investment to act as a genuine diversifier and protect your capital

Alex Burn
What’s been happening in markets?

2018 started much as 2017 ended, with continued confidence in global economic growth seeing most markets continue to rise in early January. However, late January and early February saw increased volatility as asset prices fluctuated sharply. Markets were buffeted by many factors including heightened expectations of interest rate rises. This followed stronger than expected inflation in the US as well as the emergence of unforeseen geopolitical risks.

Overall, the first quarter of 2018 was a poor one for riskier assets, leading to increased demand from investors for lower risk assets. This included UK government bonds (gilts) which made modest gains as investors’ risk appetites reduced. We think these current gains are a short term phenomenon but holding gilts in your portfolio can provide diversification and offer some protection against significant losses.

Rising interest rates hurt bonds

The UK could see two rate rises this year, following the first rise in over a decade last November, with current expectations for a May rise evenly balanced. In a rising rate environment bonds are generally perceived to lack value because when interest rates rise, the income from bonds looks relatively less attractive. Some investors could even experience a negative return when adjusted for inflation. However, we believe that government bonds could still be worth holding in your portfolio, even when they may be losing some value.

What are the benefits of investing in gilts?

We don’t believe that any one asset type such as government bonds or US shares or property for example will perform consistently well forever. If you group together a selection of assets that react differently to market ups and downs it can help reduce portfolio risk.

In broad terms, holding gilts helps to provide portfolio diversification and could help preserve your capital. We use them specifically to provide an element of protection against increases in volatility, falling equity prices or a downturn in corporate bonds. We strongly believe that this makes gilts a key element in portfolio construction.

Potentially preserving your capital

If we experience another disruptive event like the financial crisis of 2008 your portfolio will need an investment to act as a genuine diversifier and protect your capital. When the financial crisis hit markets, most investments moved in the same direction, meaning many elements of portfolio diversification became ineffective. The key asset class that could potentially offer that protection to your capital is top grade government bonds such as gilts.

A possible safe haven in a crisis

Safe haven assets are those that tend to hold or increase their value in times of crisis. People usually associate this quality with physical assets like gold or strongly backed currencies such as the US dollar or Japanese yen. However it can also be provided by certain other assets including top grade government bonds. These bonds usually rise in value during difficult times due to the significantly lower risk that government backed assets will default.

Why hold gilts now?

After a long period of relative calm and with fairly valued assets, volatility has the potentially to rise. However, if interest rates continue to rise, gilts may fall in value and look like a poor investment to hold.

The key point to remember is that even if gilts lose some value in the short term, they could still provide valuable capital protection and diversification benefits over the long term. While we’re not currently experiencing a crisis, protecting a portfolio for the long term is a priority and gilts have their part to play.

For more information, call us on 020 7562 4900, calls may be recorded.

The value of investments and any income from them can go down as well as up and is not guaranteed. You could get back less than you originally invested. Past performance is not a guide to future performance. The views expressed within this article are those of Architas, who may or may not have acted upon them. 

Alex Burn, CFA

Investment Manager

Alex leads research on Asian and Japanese equity funds as well as due diligence on passive strategies and co-manages the Global Equity Income and Passive portfolios.


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