Once-Popular UK Bond Trade Shaken by Surge in Volatility

The appeal of UK bonds is being put to the test by surging volatility, with money managers warning that one of the most popular trades in recent months now requires nerves of steel.Author of the article:You can save this article by registering for free here. Or sign-in if you have an account.(Bloomberg) — The appeal of UK bonds is being put to the test by surging volatility, with money managers warning that one of the most popular trades in recent months now requires nerves of steel.Subscribe now to read the latest news in your city and across Canada.Subscribe now to read the latest news in your city and across Canada.Create an account or sign in to continue with your reading experience.Create an account or sign in to continue with your reading experience.Britain’s government bond market has been more turbulent than peers in Europe and the US during the Middle East war, and volatility has remained elevated even after this week’s ceasefire deal. Since the beginning of March, two-year gilt yields, which have been especially sensitive to the geopolitical news, have moved by a tenth of a percentage point or more in 12 sessions, marking the most unstable period since the 2022 UK government credibility crisis.The dramatic swings have spurred Vanguard International and Royal London Asset Management to take a more cautious approach to gilts. Other money managers, including Insight Investment and M&G Investments, are warning that volatility could remain elevated.Get the latest headlines, breaking news and columns.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Top Stories will soon be in your inbox.We encountered an issue signing you up. Please try againInterested in more newsletters? Browse here.“The UK has been the market most exposed to these volatile, violent, geopolitical-led moves,” said Ales Koutny, head of international rates at Vanguard, who has closed out his bet that UK bonds will outperform Europe. “We still think the UK looks cheap, but right now you need much more stomach to take the volatility.”Prior to the war, gilts had become one of the most crowded bets in fixed income. Investors expected the Bank of England to cut interest rates in response to a weakening labor market, triggering a sharp move lower in UK yields. The conflict and the resulting surge in energy prices have upset those expectations, with investors now forced to consider the prospect of rate hikes by the Bank of England. “For about a year gilts have been looking standout cheap,” said April LaRusse, head of investment specialists at Insight Investment. “You now have a situation where suddenly everything we were focused on is being questioned.” LaRusse noted the UK is more vulnerable to inflation than other developed countries as a result of its open economy, fiscal and trade deficits, and reliance on imported energy. Gilts dropped on Friday, trimming the week’s gains. Yields rose around four basis points across the curve, with the 10-year yield just under 4.80%. At the height of the volatility in March, it hit 5.12%.“It’s been the most loved market over the last three to four months,” said Craig Inches, head of rates and cash at Royal London Asset Management. “In our global bond funds, we have had exposure to the UK, but we have kept it reasonably low risk because of the volatility.”While the war has shifted the fundamental outlook, Inches cautioned that the gilt market has also become more prone to wild swings due to concerns around the nation’s fiscal outlook. In 2022, deficit worries were a driving factor in the gilts meltdown triggered by a government tax-and-spend plan. UK bonds have recently traded more like Italian debt, which investors typically regard as a riskier bet than ultra-safe bonds issued by Germany. Over the past month, the performance of UK and Italian bonds have been in line, with returns down 0.2%, according to data compiled by Bloomberg.Beyond unnerving investors, the elevated volatility has ramifications for the wider economy. UK home buying demand nosedived in March as lenders rushed to withdraw mortgage products in response to whipsawed interest-rate swap markets. The tumult also makes the government’s fiscal planning more difficult and complicates the financing outlook for companies, which may be deterred from selling bonds.Still, there are other factors at play behind the swings. As a smaller bond market, UK moves can appear amplified compared to larger, more liquid markets. Alongside this, a structural change in demand has left gilts more exposed to the whims of flightier investors such as hedge funds, which often use borrowed cash to boost returns. That comes as demand from steadier buyers including pension funds falls.“The structure of our core government bond markets has changed hugely in the last five years or so,” Andrew Bailey, governor of the Bank of England and chair of the Financial Stability Board, said on Thursday. “There is much more leverage, pricing in the markets tends to move more.”The next major test will come during local elections in May that are shaping up to be particularly bruising for Prime Minister Keir Starmer’s governing party. Starmer faced calls to quit last year from within the Labour Party, and the prospect of a potential leadership battle looms large in the minds of investors who were scarred by the 2022 crisis that led to the ousting of former Prime Minister Liz Truss.Taken together, the risks suggest traders may take a cautious approach to the UK bond market.“There’s a bit of a semi-permanent risk premium,” said Andrew Chorlton, chief investment officer for fixed income at M&G. “It’s still paying the price for what happened under completely different governments, different regimes.”—With assistance from James Hirai and Tom Rees.Postmedia is committed to maintaining a lively but civil forum for discussion. Please keep comments relevant and respectful. Comments may take up to an hour to appear on the site. You will receive an email if there is a reply to your comment, an update to a thread you follow or if a user you follow comments. Visit our Community Guidelines for more information.