Home > News > 2003 > October 2003 > Bond investment a case for non-gilt bonds
Bond investment a case for non-gilt bonds
Chris Watts, an actuary in London's pensions actuarial team looks at the case for non-gilts for investors trying to reduce their exposure to equities.
This article first appeared in September's edition of Charity Finance.
Generally speaking institutional investors have been reducing their exposure to equities in favour of fixed interest investments - including both gilt and non-gilt bonds.
The supply of new gilts has been limited recently due to the Government's reduced need to issue debt to finance expenditure. Although few new gilts have been issued recently economists believe there will be a substantial number of gilt issues in the future due to rising government borrowing. Recent factors have brought about what might turn out to be an artificial upward pressure on gilt prices (and hence downward pressure on yields). The effect is particularly marked at the long-term end of the gilt market, because pension schemes and insurance companies, who have substantial assets to invest, tend to prefer longer dated issues. This has led to a relatively flat gilt yield curve, illustrated by the following yields available at the beginning of August this year:
| Term (years) |
Yield |
| 5 |
4.36% |
| 10 |
4.62% |
| 15 |
4.73% |
| 20 |
4.78% |
| 30 |
4.78% |
Source: FT Actuaries Indices and DMO
At the same time, the liquidity of the non-gilt bond market has improved through a number of recent large issues, making them a viable alternative to gilts. Indeed, the non-gilt sterling bond market is larger than the gilt market now, and it is likely to remain so.
A non-gilt bond is a debt security (or loan note) offering a fixed annual income and capital redemption in the same way as a gilt. They may be issued by companies (known as corporate bonds) or international institutions and supra-nationals (such as the World Bank). Because there may be a risk of default (and lower liquidity which means they may have to be held until maturity or default, if the market turns against them) non-gilt bonds typically offer returns higher than those available on gilts of equivalent term; the additional return available reflecting the additional risk of the bond. It is generally assumed that the risk of default on gilts is negligible.
Non-gilt bonds will also tend to provide a higher level of income than equivalent gilt bonds. The higher yields available on non-gilt bonds will tend to be reflected in larger regular interest payments. Of course, the higher yields are available as there is a risk that the issuer of the bond defaults on their interest payments. If the issuer defaults on the interest payments the cashflows may well be worse!
As mentioned above another reason non-gilt bonds offer higher yields than gilts is that they tend to provide lower levels of liquidity. Liquidity represents the ease that a particular asset can be sold, both in terms of the existence of potential buyers and the price that they would be willing to pay at short notice. An asset of poor liquidity might be difficult to sell at short notice and if it were, the price obtained might fall far short of the true value of the asset. Banks and other financial institutions exist (in part) to provide liquidity for assets such as corporate bonds. For many corporate bonds they will be happy to buy or sell (up to a certain amount of bonds) at particular prices at any given time. However, the price they are willing to sell at will be higher than the price they are willing to buy at. They make their profits through this difference (called the bid-offer spread). This spread it a good indication of the liquidity of a particular bond.
Non-gilt bonds are risk-rated by rating agencies such as Standard & Poor's. Credit ratings range from AAA for the most secure and liquid issues down to D for those most likely to default and most difficult to trade (often termed "junk bonds"). Only the higher rated bonds would normally be regarded as investment-grade and considered for inclusion in the portfolios of investors such as charities. Investment grade bonds are usually considered to be those with a credit rating of BBB or higher. A typical investment-grade bond portfolio might invest in a majority of AAA and AA issues (AAA lenders might include, for example the World Bank or the European Investment Bank, whereas AA lenders might include some of the largest FTSE companies or local government authorities) with a minority of A or BBB issues (perhaps issued by other FTSE companies).
Credit ratings on bonds can change from time to time - for example a few years ago some bonds issued by several of the large telecoms companies were downgraded from AA to A after they raised substantial additional capital to fund their acquisition of third-generation (3G) mobile phone licenses. The price of a bond can be expected to change when its credit rating is upgraded or downgraded. This is a source of additional volatility compared with gilts, and also an opportunity for an investment manager to add value by anticipating such movements.
The following table compares the yields available on investment-grade, non-gilt bonds with the gilt yield at the same date (across bonds of all terms).
| Credit rating |
Yield |
| Gilts |
4.6% |
| AAA |
5.0% |
| AA |
5.3% |
| A |
5.6% |
| BBB |
6.2% |
Source: Barclays capital
Diversification is a more important consideration for a non-gilt portfolio than a gilt portfolio because of the credit risk attached to individual non-gilt investments. The value of corporate bonds issued by a particular company may be related to the value of shares in that company, since both reflect the risk of investing in the same enterprise (that isn't to say the risks are the same - on liquidation the companies assets will be paid to the holders of bonds and other creditors before any is paid to shareholders). In the same way that it is sensible to diversify equity investments it is normally appropriate to spread a corporate bond portfolio across as many issues and issuers as possible. This requires careful management. Pooled funds are often a convenient vehicle for achieving appropriate diversification.
Although a non-gilt bond would normally be expected to yield a higher return than an equivalent gilt, over the duration of the bond it will be subject to different short-term market pressures. For this reason inclusion of non-gilts as part of a charity fund's bond strategy will normally require a review of the current investment benchmark to ensure consistent measurement of performance over the short-term. This would also serve to distinguish genuine long-term outperformance of the fund manager, as opposed to simply confirming that non-gilt bonds have indeed out-yielded gilts.
Charities may like to allocate some of their bond portfolio to index-linked gilts, rather than fixed-interest gilts, as a better match for inflation-related outgoing. Currently the index-linked non-gilt market is very small, and so schemes would have to accept greater inflation-related risks in pursuing a non-gilt strategy. However, some market commentators would argue that inflation protection is less important now than in the past, with inflation arguably under greater control - with political lessons perhaps having been learned from past mistakes.
There is also an argument that index-linked gilt yields, and to a lesser extent fixed-interest gilt yields, have been affected by recent increased demand from pension funds and so provide a less attractive investment than in the past.
The projected outgoings and the tolerance of the trustees for investment risk should drive the strategic asset allocation of the scheme, and in particular the balance between longer term and shorter term assets. Exposure to a diversified portfolio of non-gilt bonds, compared with a gilt-only strategy, may offer the opportunity for enhanced fixed interest returns for only a small amount of extra risk, thus improving the overall risk-return relationship.
Whether it is appropriate for a particular charity to invest in non-gilt bonds, the extent to which a charities bond portfolio might comprise non-gilts, and the timing of such investments, are all important strategic and tactical asset allocation decisions that should be carefully considered in light of the charities circumstances.
This article first appeared in September's edition of Charity Finance.
Chris Watts, October 2003.