We have a budget due on Wednesday, 30 October 2024. If this budget is poorly received by the market, gilt yields could rise again. This may lead to losses, especially for longer-dated gilt holders, whose higher interest rate risk makes them more vulnerable.
It's a risk that is already on the table; investors don’t have to wait until budget day to see its effects. If you are concerned about the potential fallout, the only practical solution is to shorten the duration of your portfolio. Who is particularly affected?
Gilts are often seen as risk-free investments—after all, they are backed by the government, and the expectation is that the government will always repay. However, while repayment is virtually guaranteed, the value of gilts can fluctuate significantly. This makes them far from risk-free for investors looking at market value, particularly those managing positions on a mark-to-market basis. Even if you hedge with swaps, there's no guarantee that credit spread risk won't move against you, creating unexpected losses.
One of the key considerations when investing in gilts is understanding that longer-dated gilts carry more risk. Simply their interest rate risk and spread risk are greater. The only effective way to reduce this risk is to shorten the maturity or duration of the holdings.
The risk posed by changes in government policy can further complicate matters for gilt investors. This is particularly relevant when considering how both interest rate and spread risks can interact with broader fiscal decisions.
A clear example of this was the mini-budget announced on 22 September 2022, which included significant tax cuts and expansionary fiscal measures estimated at £45 billion per year.
The markets reacted negatively, and gilt yields spiked sharply—specifically, the 30-year gilt yield increased by 120 basis points over just three days, one of the largest increases ever seen in such a short period. This dramatic rise was driven by concerns about the government's ability to finance these cuts, potential inflation, and future borrowing needs.
The upcoming budget serves as a timely reminder for investors managing gilt portfolios to reassess their strategy. If your primary goal is to find a safe place to park liquidity do you need to run these risks? Shortening the duration is an option that is open to you.
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