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Do you need a passive approach for gilts?

Do you need a passive approach for gilts?

Friday evening should be a time for high spirits, but last week Moody’s turned mood-hoover by downgrading the UK’s credit rating as the first end of week beers were being sunk in the City.

The agency moved Britain's long-term issuer rating from Aa1 to Aa2, arguing that the outlook for the UK’s public finances had ‘weakened significantly’ with the government’s fiscal management ‘increasingly in question’ and the debt burden expected to continue to rise.

These concerns were exacerbated for Moody’s ‘by the erosion of the UK’s medium-term economic strength that is likely to result from the manner of its departure from the European Union’.

Don’t spoil the mood

The government responded quickly. ‘The assessments made about Brexit in this report are outdated,’ the Treasury stated. ‘We are not complacent about the challenges ahead but we are optimistic about our bright future.’

For investors in gilts, the news may have seemed superficially negative. Yet any alarm is probably misplaced: after all, the UK pays interest on its bonds in a currency it controls and has taxation powers for raising revenues.

Indeed, if Moody’s is correct about the economic situation, the Bank of England is less likely to raise interest rates – and may even cut them further – which should be positive for gilts.

It’s also possible to see whether this kind of environment would be supportive for active gilt funds by looking back in history. In February 2013, Moody’s lowered the UK’s rating from AAA to Aa1 and changed the UK’s outlook from stable to negative in 2016.

After the first event, the average gilt manager did just about eke out positive risk-adjusted returns, with a personal information ratio of 0.05 according to Citywire Discovery. However, this dropped to -0.04 for the three-year period after that downgrade.

During the 12 months following the issue of the negative outlook in June last year – a time that included the Bank of England cutting interest rates – the average gilt manager fared far better with a personal information ratio of 0.21.

This reflects well on active funds in the sector, suggesting they have used their ability to manage duration in their portfolio astutely.

The passive route

Of course, passive investors also have the option of increasing or decreasing the duration of their gilt exposure, albeit through blunter instruments.

For example, iShares has a 0-5 years gilt ETF with a 0.2% total expense ratio (its distribution yield is 0.53%, compared with the five-year index’s yield of 0.76%). Lyxor has a gilt ETF with the same 0-5 year mandate, although it is far smaller – with just £102 million of assets to the £1.4 billion in the iShares product – despite a lower total expense ratio of 0.07%. The iShares fund is clearly the preferred vehicle for trading and tactical allocations, then.

Pimco has an actively managed strategy in this space – the Pimco Sterling Short Maturity Source ETFSPDR Barclays Capital UK Gilt ETF, charging 0.35% – but its exposure is not solely to gilts and inevitably shifts over time. For instance, its weighting to government bonds went from 9% on 31 August to 31% on 21 September.

Despite its fees, the £269 million ETF has outperformed its Bank of America Merrill Lynch British Pound 3-Month Deposit Bid Rate Constant Maturity index by 45 basis points over the past year.

At the other end of the duration spectrum, the tiny £16 million SPDR Barclays 15+ Year Gilt ETF has a total expense ratio of 0.15%.

For investors declining to make such duration calls, there are several more generic gilt ETFs. The £1.6 billion iShares Core UK Gilts ETF again costs 0.2%, with an effective duration of 10.98 years. The Lyxor FTSE Actuaries UK Gilts ETF is once more cheaper but smaller, with a total expense ratio of 0.07% and £185 million of assets, and has a slightly longer modified duration of 11.08 years.

The £117 million SPDR Barclays UK Gilt ETF levies 0.15% with an even longer effective duration of 12.05 years, while the £110 million Vanguard UK Gilt ETF has the longest duration at 12.5 years with fees of 0.12%.

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