Bond Watch: what a Labour win could mean for gilts

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.                 

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.                

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How politics could affect gilt yields

With the UK election just a month away, bond investors will be carefully watching the policies of the two major parties to assess how they could impact the economy.

Too much unfunded spending could fuel inflation, leading to lower bond prices and higher yields, but on the other hand fiscal responsibility would be welcomed by markets and the Bank of England, which could boost gilt prices.

With Labour leading the polls, what could an election win mean for markets? The consensus view is that Labour would not change economic policy too drastically and they would not announce unfunded tax cuts. This suggests a smooth ride for gilt markets as the election approaches.

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But Legal & General Investment Management (LGIM) reckons there will be an impact on markets from politics, no matter who wins.

It says it expects investors will increasingly focus on the continued political pressure to push the spending envelope higher as public dissatisfaction with UK public services rises, with the potential for upwards pressure on gilt yields as a result.

Alex Mack, head of rates and inflation at LGIM, adds: “So, does that mean whoever wins the next election could have to issue lots of bonds? Yes, but we strongly believe that the main impact of a UK government decision to spend and borrow more will primarily come via expectations for future Bank of England rate moves.”

‘The outlook for nominal bonds remains poor’

Capital Gearing (LSE:CGT) manager Peter Spiller, in the investment trust’s annual results, said that a long-term higher inflation environment would be bad news for bonds.

Higher inflation eats into the real return that bonds offer, and would force central banks to keep interest rates high.

However, Spiller says the outcome for inflation-linked bonds is more “nuanced”. His strategy has 43% invested in this type of asset.

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​​​​​​​Spiller says US government issued inflation-linked bonds have real yields of above 2%, meaning that their coupons and principal payment on maturity currently return 2% above the US inflation rate for investors buying the bonds today.

Spiller says real interest rates at these levels will not be sustainable if there is no prospect of bringing fiscal deficits under control. If real rates fall, that means inflation-linked bond prices are rising.

“Left unchecked, financial repression – characterised by negative real interest rates – will be necessary,” Spiller says.

In this environment, he says inflation-linked bonds would perform well, even if there could be short-term correlations with normal bonds – those without inflation linkage.

“If nominal bonds are weak, as seems plausible, index-linked will most likely suffer with them. Yet the long-term prospects look fair or, should financial repression be enacted, excellent [for inflation-linked bonds].