Benstead on Bonds: political stability at last for gilts

Uncertainty is one thing financial markets hate more than anything else. Uncertainty comes from various directions, including whipsawing economies and politics, which has a negative impact on stock and bond markets.

We saw it during the early days of the pandemic, when stock markets plunged as investors tried to gauge the impact of lockdowns. And we saw it most acutely in bond markets when Liz Truss and Kwasi Kwarteng launched a series of “growth-boosting” tax cuts and government spending pledges, but did not provide a plan to fund the extra outgoings. The result was a sudden spike in gilt yields, as investors demanded a higher premium to lend money to the UK government.

• Invest with ii: Buy Bonds | Tax Rules for Bonds & Gilts| General Investing with ii

After three prime ministers and five chancellors since 2019, Sir Keir Starmer could now deliver political stability to the UK, fund managers believe.

The reaction in gilt markets to the Labour victory, with 411 out of 650 seats, was calm. The gilt market gives investors clues about confidence in the government to deliver a stable and conservatively run economy. If investors lose confidence, then they demand a higher interest rate to lend money, which means higher yields in secondary gilt markets as well as higher yields on newly issued bonds.

Gilt yields are a little over 4% currently (as at mid-July), with the 10-year paying investors 4.1% a year, if held to maturity. Yields fell slightly the day following the election, but as a Labour majority was widely expected, there was not a big market move.  

• Fund managers give their take on what Labour's win means for markets
• What Labour’s landslide means for investors

Chris Iggo, chief investment officer at AXA Investment Management, says that it made sense that gilt and equity markets reacted positively to the election, due to both lower political risk and the prospect of Bank of England interest rate cuts.

He said: “The last time Labour took office after an extended period in opposition and achieved a sizeable majority of seats was in 1997. A month after the election, the FTSE 100 was 4% higher and gilt yields were 0.22 percentage points lower. A year on and the FTSE 100 was up over 35% and gilt yields were 1.6 percentage points lower.”

What to expect from Labour

So, how will Labour govern for the next five years? There was not much detail in its manifesto, but the general view is that it will be a fiscally responsible government that will take important steps to improve economic growth.

Their manifesto said it would prioritise growth and any budgetary ambitions would be fully funded, as well as building a closer relationship with Europe, and reform of the energy and construction sectors.

This suggests that gilt yields will be stable or fall, which would be a result of rising demand. Investors therefore will pick up a good income from their bonds, but also have the potential to see capital values rise as well.

One advantage for Labour, according to David Zahn, head of European fixed income at Franklin Templeton, is that their strong majority means that legislating their agenda should be fairly straightforward.

“Investors will be most interested in the first budget in October where we will learn the plans Labour have for the economy, spending and financing of the government. There should now be a period of stability in UK politics as this Parliament should last five years giving the Labour Party time to implement their agenda.  

“We anticipate Labour wanting to maintain the fiscal responsibility without any major structural changes which should be supportive for UK gilts, especially as we anticipate the Bank of England to embark on their interest-rate cutting cycle,” he said.

• Sign up to our free newsletter for share, fund and trust ideas, and the latest news and analysis
• Bond Watch: Labour landslide calms bond markets

But he notes that in the longer term the “political discord” in the UK should not be underestimated as Labour won just 34% of the popular vote but received 64% of the seats in Parliament due to the first-past-the-post approach. 

“Therefore, Labour should craft policies to help bring the remainder of the voters towards Labour. Investors will have to see if the Labour Party are thinking along these lines,” he said.

There are clues that the Bank of England is about to cut interest rates. The first clue, according to Joost van Leenders, a senior investment strategist at Kempen, is that the Bank said that June’s decision was balanced, which points to more policymakers tending towards cutting rates.

Second, he notes that the Bank of England will closely re-examine the extent to which the risks of stubborn inflation are declining when new forecasts become available in August.

“It’s far from a promise but in central-banker jargon this translates into a hint. A cut to interest rates in August would also mean that the Bank of England is slightly ahead of the Federal Reserve in this respect,” he said.

Bonds look set for more growth

With interest rates on the cusp of falling around the world, investors could see capital gains from their bond positions. When rates fall, bond prices tend to rise as the fixed income they offer becomes more valuable. They can therefore behave as a diversifier to equities in a portfolio, bolstering income and capital when stock markets drop and central banks step in to stimulate economies.

A Labour government looks set to boost the case for gilts and bonds, and I expect the asset class to continue growing among retail investors.

The amount of money held in fixed income - across dedicated bond funds and direct holdings such as gilts - has risen nearly three times in the past two years among customers of ii.

• Everything you need to know about investing in gilts
• Annuities versus gilts for retirement income – which is best?

Assets held in direct gilts are up nearly 21-fold (2,019%) since 30 June 2022. The most-popular gilts are UNITED KINGDOM 0.25 31/01/2025 (LSE:TN25), UNITED KINGDOM 0.125 30/01/2026 (LSE:T26), UNITED KINGDOM 0.125 31/01/2028 (LSE:TN28), 5% Treasury Stock 2025 (LSE:TR25) and UNITED KINGDOM 0.375 22/10/2026 (LSE:T26A).

These are all bonds maturing soon, and with the exception of TR25, have low coupons and trade a discount to their £100 par value. This means that most of the return comes from the difference between the price paid for the bond and the return of the £100 principal at maturity, rather than from coupon payments. Capital gains are tax free on gilts, whereas coupons are taxed as income.