Gilts to the fore as yields increase

Wednesday, 16 November 2005 12:00

The yield and performance of government-backed bonds (gilts) is set to climb in the months to come, as major economies raise interest rates and emerging markets strengthen their economies.

An analysis from Insight Investment Management predicts that actions by central banks in the US, Japan and Europe will increase yields there while emerging markets still have much to offer investors.

"The US Federal Reserve has been steadily raising interest rates throughout 2005, and looks set to continue into 2006," said Adrian Grey, head of fixed income at Insight.

"Continued strong economic data and the accompanying hawkish comments from Fed officials lead us to believe that the peak in Fed Funds will come in the middle of 2006 at around 4.75 per cent."

But while rates have been climbing Stateside for some time, there is also set to be upward pressure on gilts from other areas.

"What is new for the global economy is the growing realisation that the Fed is likely to be joined by the Bank of Japan (BOJ) and the European Central Bank (ECB) next year," he added.

"The BOJ is likely to move away from its zero rate policy as Japan finally sees inflation turn modestly positive. Moreover, the ECB is uncomfortable with continued strong growth in money supply, and markets are now pricing-in the onset of rising European rates."

But these movements will not see a sustained rise in returns - given the low inflation environments that still persist.

"All this has put upward pressure on bond yields around the world in recent weeks. This may continue for a while longer, particularly in shorter maturity bonds. But any further sell-off in longer dated bonds will be contained by the relatively modest inflationary threat," Mr Grey explained.

"Consequently, the key implication of this global monetary tightening is likely to be flatter yield curves rather than much higher bond yields."

Looking to emerging markets Cathy Elmore, emerging market debt fund manager at Insight, has found cause for optimism there as well - despite tightening spreads.

"Considering the improvement in these countries' economic management over the last few years - of the 32 countries in the benchmark index, Standard and Poor's has upgraded 13 in the last 12 months, and improved the outlook on the rating on a further five - a reduction in the risk premium should be expected," she said.

"Furthermore, for investors seeking yield, emerging markets have offered a good pick-up over alternative asset classes, particularly when the quality improvements and liquidity aspects are added to the equation."

She added: "While it can be expected that lower rated credits will underperform in this environment given their vulnerability, those credits that are continuing to improve will not bear the brunt of a sell-off and are likely to recover more swiftly.

"For example, Russia is spending its windfall from high oil and gas prices to retire debt, and Bulgaria has been implementing reforms as one of the next wave of EU accession countries."

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