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How Low Can Gilts Go?

Despite the high debt of the British government, these 10-year bonds are still considered a safe haven.

Yields on 10-year U.K. government bonds have fallen below 2 percent for the first time since they were launched more than half a century ago, cementing their reputation as one of the global investment market’s most important safe havens.

Predictions that rates on U.K. sovereign bonds—known as gilts—would sink at the close of 2011 to record low levels would have seemed outlandish at the beginning of the year, given the U.K. government’s high debt and gaping deficit.

Nevertheless, gilt yields dropped to as low as 1.997 percent on Friday—down 140 basis points from last year’s close—despite a plethora of potentially bearish factors. These include lower tax revenues and economic growth than expected in 2011, fears of a return to recession in 2012, and high inflation. They ended Tuesday at 2.04 percent. 

Investors largely credit the fall in yields to gilts’ growing safe-haven status amid fears about euro zone sovereign debt. Many also attribute high gilt prices to the unusually long maturity of U.K. government debt, which decreases the risk that the supply of debt that has to be issued will exceed the demand for it from investors. George Buckley, chief U.K. economist at Deutsche Bank, said that because of this prolonged maturity “the current debt burden looks sustainable over the next decade.”

The fall in yields on gilts is closely bound up with countervailing trends in other sovereign markets. Ten-year Italian yields are, at 6.97 percent, 210 bp higher than at the end of 2010. Moreover, although rates for Bunds closed 9 bp below gilts on Friday, at 1.95 percent, the Bund market has gyrated in recent weeks on fears that the German government’s debt burden could rise to unsustainable levels should it be forced to bail out Italy and other troubled euro zone states. For this reason, in November Bund yields briefly rose above those of gilts for the first time in more than two years. Although the return since then to high Bund prices shows that many investors still see them as a safe place to park money, some are still anxious to avoid any euro zone government debt at all because of the bloc’s debt imbroglio.

Gilts have also benefited from this year’s global flight away from riskier assets such as equities, because of disappointing economic growth. It is specifically gilts, rather than sterling assets as a whole, which have attracted investors: the FTSE 100 index of large-cap U.K. stocks closed at midday on Friday at 5,513, 8.3 percent below last year’s close. The fall in the U.K. stock market reflects the spluttering nature of U.K. economic growth, which has depressed expectations for corporate earnings. Official statistics published on Thursday showed that although the economy grew a respectable 0.6 percent in the third quarter, it failed to expand at all in the second. Recent survey data suggests that output may have shrunk in the final quarter of this year, and economists at Schroders predict it will contract by 0.5 percent in 2012 because of fiscal austerity.

Britain’s unlikely combination of low economic growth at best, tight fiscal retrenchment and stellar government bond performance has puzzled many people, including much of the French government. Its prime minister, finance minister, and even the head of its central bank have in recent days responded to the possibility that France might lose its treasured triple-A debt rating by suggesting that the U.K. is in a worse fiscal position than the Fifth Republic. French 10-year debt closed at 3.02 percent on Friday—98 bp above equivalent gilts. 

Gilt bulls say this reasoning is flawed for three main reasons.

The U.K.’s long average debt maturity, which at 14 years is almost double France’s and far higher than any other European country’s, allows it to avoid the kind of liquidity crisis to which other states are prone. Italy is already in a liquidity crisis, since investors doubt its ability to meet its need to roll over hundreds of billions of euros of debt in the coming year.

The U.K. coalition government which came to power last year has set out a plan to cut the deficit through severe retrenchment, and markets have so far believed ministers’ repeated assertion that there is “no Plan B” for fiscal policy based on a liberal loosening of the purse strings. Britain’s fiscal deficit is expected to stretch to 9.4 percent of national income this year, compared with only 5.7 percent in France for example. But analysts regard the deficit’s likely downward direction of travel as more important than the size of the deficit itself.

Analysts also see as crucial the Bank of England’s ability to rescue the government from default by buying its debt in massive quantities. The European Central Bank—the central bank for France and the other euro zone member states—has no such carte blanche. 

For all these reasons, gilt yields keep falling despite Britain’s uninspiring economic outlook—although even gilt bulls warn they have become so low that there is little room for them to fall further in the new year. 

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