Benstead on Bonds: is there a gilt crash coming in 2023?

There will be record amounts of gilts entering the market over the next few years – but who will buy them all?

Basic economics says that supply and demand are crucial to asset prices. Too many sellers and prices fall, too many buyers and prices rise.

Applied to the gilt market, which is one of the most important bond markets for UK investors, the signs are worrying: a record £255 billion in UK government bonds will enter the market in the 2023 to 2024 tax year, according to Royal Bank of Canada calculations, with that figure expected to be more than £100 billion a year until 2028.

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Not only is the government issuing record amounts of debt to pay for spending, such as the energy price guarantee, the Bank of England will continue selling off its vast gilt portfolio built up during a decade of quantitative easing, in a process known as quantitative tightening. This means that the “net” issuance, which accounts for both the Bank of England’s and the Treasury’s actions, is going to be unprecedented.

Gilts form the backbone of many, but particularly conservative, investors’ portfolios. There is no currency risk and the Bank of England is all but guaranteed to honour its debts. While most gilts are bought by large, “institutional” investors to cover pension liabilities and build defensive portfolios, they also end up in DIY investors’ accounts via multi-asset portfolios, such as Vanguard’s popular LifeStrategy range or alternatives offered by workplace pension groups.

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After the crash in gilt prices this year due to higher interest rates, yields are now around 3.5% across bonds maturing in one to 50 years, which is not a bad level of income if inflation subsides, and makes gilts more much more attractive and important for investors compared with a year ago when yields were less than 1%.

Will there be enough demand for gilts?

Seamus Mac Gorain, head of global rates at J.P. Morgan Asset Management, told me there is no modern precedent for the amount of gilts which will need to find buyers next year.

He said: “The big difference is that in previous periods of heavy gilt supply, the Bank of England has been buying gilts. This time, the Bank will be selling. The eurozone will also see a large increase in net bond supply, as the ECB also starts reducing its balance sheet, but the change is not as pronounced as in the UK.”

Rufaro Chiriseri, head of fixed income for the British Isles at RBC Wealth Management, argues that oversupply darkens the gilt outlook even though the government has committed to borrowing less money.

Chiriseri said: “The recent spending cuts and tax increases, totalling £55 billion by the end of tax year 2027–28, significantly reduce the government’s debt issuance requirement, which the UK Debt Management Office has reduced by £24.4 billion to £169.5 billion for the current tax year. Still, the net supply of gilts for the current and subsequent tax years is forecast by RBC to be above record highs — a clear negative for gilt yields.

“The challenge will be whether demand for gilts can meet the supply deluge. We have a negative outlook for gilts in the first half of 2023.”

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But just because more UK government bonds are coming on to the market does not mean that there won’t be enough demand.

Jon Day, a global bond portfolio manager at Newton Investment Management, says bond demand is affected by what goes on in the boarder world.

He told me: “If inflation drops dramatically and we have a recession and unemployment – then demand for safe haven gilts goes up at the cost of equities. A bad macroeconomic environment is good for bond demand, so long as inflation falls back down. If inflation is falling then a 3.5% on a gilt yield won’t be a bad investment.”

However, Day says that this would all change if inflation did not fall and stayed around 4.5%.

“That would be bad for bonds as yields are below that, giving investors a loss in real terms. Yields would have to therefore rise, which would come about through falling gilt prices, to make those bonds attractive to investors.”

Should you avoid gilts?

Mac Gorain thinks that overall demand for government bonds will be stronger next year, as inflation moderates and investors increasingly start to focus on the likelihood of recession in the US later in the year. However, he says that gilts will still underperform other safe bonds.

He said: “We expect UK gilts to underperform, as it is the market where the increase in net supply of bonds to the private sector is most pronounced.

Day adds: “Next year the UK will run a big fiscal deficit – and also a big current account deficit. Twin deficits are not good when investor capital is more sought after.

“How will the UK attract bond buyers? Either the currency goes lower or yields go higher. Something has to give to give investors a reason to invest.”

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Day says investors will do better with debt from emerging markets, where yields are higher and central banks have been proactive in the fight against inflation.

He also likes bonds from the New Zealand government, where the central bank has been aggressively raising interest rates.

Day said: “There has been lots of interest rate tightening and big housing debt issues in New Zealand – so growth will slow and yields will fall as rates can be cut. Investors need to be looking at bonds where they are being paid well to take risk, because at least they get the income. New Zealand bonds yield 4.25%.”

Nevertheless, investors should not dismiss gilts completely due to the looming oversupply issues. If there are not enough buyers for UK bonds, then prices will fall and yields will rise. This could – like in September following the mini-budget – offer up an opportunity to buy bonds at bargain prices.

“Gilt yields in September at 4.5% were very attractive. They can become attractive again very quickly,” Day says.

Another positive is that the current government, led by Rishi Sunak in Number 10 and Jeremy Hunt in Number 11, is embracing fiscal responsibility by cutting spending and raising taxes.

This should help to maintain long-term confidence in the UK, meaning that short-term spikes in gilt yields may be good investment opportunities as the overall outlook for gilts is still positive and the government is very sensitive to the views of investors.