Gilts short term strategy?

[GoSeigen]

dealtn explained it in reasonable detail above. The yield of a gilt is based not on the [real] value of the next coupon but on the value of the entire stream of coupons (discounted). For longer gilts, that's a lot of coupons.

If the market determines that increases in the monetary interest rate will result in a lower inflation rate for some years and they still require the same real yield, then the nominal yield of long-term gilts will fall, not rise.

Similarly, if the market determines that low real monetary rates combined with an increased money supply and a central bank holding a large proportion of government bonds will result in potential difficulty for the government servicing its debt and/or the central bank controlling future inflation then long-term yields may rise notwithstanding any short-term fall in monetary rates.

You will note that the yield curve is currently inverted. This is not the normal state of affairs and is likely to reverse at some point. That implies short yields falling much faster than long yields, or even long rates rising while short yields fall. This is why I repeatedly warn about buying longer-dated gilts at this time. There is ample scope for disappointment notwithstanding the much lower prices of gilts now relative to a couple of years back.


GS

Hum, well I do get that prices are set by market sentiment driven by the market's view of future real return expectations (and is why I'm a hold-to-maturity "saver" type ), but I still don't think that gilt prices going up when interest rates rise is a fair generalisation.

Ah, no-one claimed it was a fair generalisation. A common and not anomalous scenario is more like it.

The view that yields rise when interest rates rise is NOT a textbook view. It is a description of just one of a range of outcomes. I think the textbook view is that the market can set yields to whatever value it deems sensible at the time, no matter what interest rates are. Often there will be a correlation, occasionally yields will be on crack.

For most of the last two or three decades, when the yield curve has not been inverted, a drop in short term interest rates has resulted in a drop in long(er) term yields, as the view has been that the lower rates were here to stay. Indeed, the drops in interest rates after the 2008 debacle, and resultant drop in long term yields, was due to fear of deflation.

So, yeah, sure, if the market thinks that increases in the interest rate will result in lower inflation, but they might not, so I don't think it's a good generalisation and, while certainly not absolute, I think the more textbook view is probably a better one, at least as far as generalisations go.

Over the long term maybe (certainly) you can observe a correlation of long-term bond yields with average interest rates. Interest rate changes take effect instantly though, so are a short-term phenomenon; I think it's therefore fair to consider shorter-term implications for bonds of all tenors.

If you think 2008 is a good example of what you are saying then perhaps you are not familiar with the Greenspan Conundrum -- where long-term yields failed to rise while the Fed was raising the Funds rate in the mid-2000s.

P.S. Edit...

My point is this. Bond prices always move in inverse relationship to their yield: that is a mathematical certainty. They DO NOT necessarily move inverse to (monetary) interest rates because neither do bond yields track interest rates exactly. Bond yields are set by the market (via price) based on its assessment of the effect of those rates; but there is NO direct mathematical relationship with interest rates.

Yep, there we do agree. They do not necessarily move either way to changes in monetary interest rates.

Oh, now has this all been an argument about semantics? Significance of smiley kicking in:

It is perfectly normal that gilt prices yields go up when (policy) interest rates also go up, and vice versa fall when that interest rate falls.

It's possible I misinterpreted this as a correction of dealtn's remark whereas you were just wryly saying that actually either prices could go up or yields could go up???

It might have been clearer to me if you had switched "down" for "up" rather than "prices" and "yields"...

EDIT: LOL! Ah, yes, I see. A classic case of over focussing on one thing!



GS

[mc2fool]

EDIT: LOL! Ah, yes, I see. A classic case of over focussing on one thing!



GS

Indeed.

[bluedonkey]

Meanwhile back at the gilt edged coalface, I have bought some TN25 to add to my TN24. That'll do for some time, probably until TN24 redeems.

[monabri]

Meanwhile back at the gilt edged coalface, I have bought some TN25 to add to my TN24. That'll do for some time, probably until TN24 redeems.

and have a virtual +1 extra for good measure !!

[Steveam]

Thank you all for a very interesting thread (and the useful links - especially the one to Index Linked Gilts.) This is not a subject I know anything about and I’ve always stuck with equities and, to a limited extent, options. This thread has opened my eyes a wee bit although I still don’t understand the details.

AIUI I can treat short term Gilts as a cash management and tax management tool. I currently have far, far too much cash on deposit at 4 or 5% awaiting deployment. This cash is outside ISAs or SIPPs which are fully utilised. I’m paying tax at a marginal 45% and interest is all taxable. I generally exceed my CGT allowance although judicious use of carried forward losses keeps me near to the allowance.

I’m now tempted to take bank savings generating interest (taxable at 45%) and buy short term, low coupon, IL Gilts. Although I usually feel that a little knowledge is a dangerous thing here I feel it’s a bit of a no brainier (in fact I feel I’ve been rather dumb in not doing this sooner - I hadn’t realised that Gilts were excluded from the CGT regime).

To be very clear: I’m not looking at Gilts as an investment proposition nor am I looking at longer term Gilts. This might happen in the future but not at the moment.

Many, many thanks to everyone here.

Best wishes,

Steve

[GeoffF100]

Although I usually feel that a little knowledge is a dangerous thing here I feel it’s a bit of a no brainier (in fact I feel I’ve been rather dumb in not doing this sooner - I hadn’t realised that Gilts were excluded from the CGT regime).

Corporate bonds bought directly from the issuer and issued in pounds are also exempt from CGT:

https://www.ii.co.uk/bonds/tax-rules-fo ... -and-gilts

[Lootman]

I feel I’ve been rather dumb in not doing this sooner - I hadn’t realised that Gilts were excluded from the CGT regime

It didn't really matter until very recently since gilts traded over par for the vast majority of the last 40 years, so you would end up with a capital loss that you could not use to offset gains elsewhere.

But back in the 1970s buying short-dated gilts was a well-known strategy for high net worth individuals to mitigate their taxes. And now it has come back into fashion due to the freakishly low yields that gilts were issued at in the very recent past. Basically you are converting (taxable) interest income into (untaxed) capital gains, and it will work until either rates decline dramatically during the next crisis. Or when a future government abolishes the CGT exemption because too many people are using it.

But it is a cash management strategy and not an investment strategy. The next time we have a year where shares go up by 20% or 30%, people might regret piling into gilts for a 5% return.

[Alaric]

But back in the 1970s buying short-dated gilts was a well-known strategy for high net worth individuals to mitigate their taxes. And now it has come back into fashion due to the freakishly low yields that gilts were issued at in the very recent past. .

It worked best with Gilts that were low coupon. There were some of these left over from the late 1940s and 1950s. I think 3% was about the lowest. Gilts were so varied in coupon that there were separate indexes for low, medium and high coupon as well as short and long dated.

[mc2fool]

BTW, at risk of backing away "from the gilt edged coalface" again (although I promise to get up to it again before the end of this post)....

Yep, there we do agree. They do not necessarily move either way to changes in monetary interest rates.

Oh, now has this all been an argument about semantics? Significance of smiley kicking in:

It is perfectly normal that gilt prices yields go up when (policy) interest rates also go up, and vice versa fall when that interest rate falls.

It's possible I misinterpreted this as a correction of dealtn's remark whereas you were just wryly saying that actually either prices could go up or yields could go up???

It might have been clearer to me if you had switched "down" for "up" rather than "prices" and "yields"...

That was, indeed, what I originally thought to do but then I'd have had to also have changed "fall" to "rise", but the way I did it meant only one edit.

In any case, no, I'm not trying to double talk you here, actually I think we're in general agreement but were maybe focussing on different aspects in that I was thinking of overall effects rather than immediate ones, and the discussion has developed along the way anyway.

As you say, gilt yields are set by the market and don't necessarily have any relationship to changes in policy interest rates, agreed. And, while it may be a common and not anomalous scenario, is why I said that gilt prices going up when interest rates rise isn't a good generalisation -- and, indeed, neither is my "correction", in the immediate term (at least, for some gilts; see below). However, I was thinking more about "Over the long term maybe (certainly) you can observe a correlation of long-term bond yields with average interest rates" (over focussing on it, you might say. )

The first chart below demonstrates both points: that the short term reaction to changes in BoE rates is sometimes with and sometimes against and sometimes apparently neither, but the overall trend of gilt yields follows the overall trend of BoE rates. (The 10 year gilt at least, this was the only long term gilt yield vs BoE rate chart I could find).

Now, to return to the coalface, the posters in this topic appear to be mostly interested in short dated gilts (indeed, the OP was specific about 2 year ones), and according to https://www.reuters.com/world/uk/uk-gilts-slide-again-inflation-fear-spreads-through-market-2023-05-25/

"LONDON, May 25 (Reuters) - British bond prices tumbled again on Thursday as investors added to bets that high inflation will force the Bank of England to carry on raising interest rates, with two-year gilts on track for one of the biggest weekly falls in 20 years.
:
The two-year gilt yield , which is especially sensitive to BoE rate expectations, rose on Thursday to its highest level since Sept. 29 at 4.55%, up 18 bps on the day."

Yes, "expectations", not actual, but I thought I'd see if I could check it against actual. I couldn't find a longer term 2 year gilt yield vs BoE rates chart but the second chart shows 2 year gilt yields over almost the same period as the first chart, so one can at least do an eyeball comparison of the gilt yield in the second chart with the BoE rate (red line) in the first.


https://www.lsh.co.uk/explore/research-and-views/view-points/2022/october/yielding-to-pressure

2 year gilt yield

https://www.cnbc.com/quotes/UK2Y-GB

[1nvest]

Statista projections for UK inflation



Nominal Gilt prices tend to rise as interest rates decline, prices decline as interest rates rise i.e. lower prices = higher yield (interest rate) to reflect general higher yields/interest rates.

Index Linked Gilts do similar but in reflection of REAL interest rates such as changes in the 10 year nominal gilt yield minus inflation.

Gilts closer to their 100 maturity price will see less price volatility. Gilts with many years to maturity will see high price volatility - as the effects of any changes in inflation/interest rates are compounded over more years.

I see NS&I are offering a new near 5% net (of 20% taxation rate) bond (6%+) as of today.

If inflation does drop off anywhere near like what Statista are projecting then there's likely to be high Gilt prices volatility. Significantly lowering inflation is likely to drive stock prices volatility. Each has to decide where they prefer to take (or reduce) risk and the potential rewards (cost). If for instance you buy into index linked gilts and saw inflation drop right off to be left with perhaps a 0.5% total nominal return when stocks had risen 25% or more, that's comparable to having taken a 25% hit.

With fixed income at least you know at the time of purchase exactly how much total return you will get when the bond is held to maturity.

[mc2fool]

P.S. to my previous post. Out of a combination of procrastination on what I was supposed to do this afternoon and an excuse for playing with Photoshop, I've combined the two charts in my last post, above, to show historic 2 & 10 year gilt yields against BoE base rates.

Don't take it as overly exact, as the granularity of the 2 year chart is a point every three months and the other chart has ticks every even year's Septembers vs at the beginning of every odd year, so lining them up was a bit fiddly, but as an overview, well, see for yourselves ...

[GoSeigen]

The period from about Sep 1994 to Sep 2004 is instructive: first a period (to late 1998) where rates rose but the ten-year yield sank, followed by a period when rates fell significantly but the ten-year barely changed.

The two-year tracks interest rates far more closely, as should be expected.

GS

[GoSeigen]

You will note that the yield curve is currently inverted. This is not the normal state of affairs and is likely to reverse at some point. That implies short yields falling much faster than long yields, or even long rates [b]rising while short yields fall. This is why I repeatedly warn about buying longer-dated gilts at this time.[/b] There is ample scope for disappointment notwithstanding the much lower prices of gilts now relative to a couple of years back.

This is exactly what is happening. Three quarters of the US inversion has gone and it's due to long yields rising faster than short yields.

The trend looks set to continue with no sign of recession or the Fed needing to lower rates; inflation still stubbornly high and a very strong jobs report yesterday.

Also, UK yields seem to be following US yields (no sign of "decoupling") with long gilt yields now above Liz Truss levels.


Hopefully the OP is happy that he bought at the short end!


GS