Analysis & Comment:  

Much has been written about the deterioration in the credit quality of UK sovereign debt and with the prospect of massive ongoing supply of gilts and a shrunken economy the prospect of the country’s credit rating bumping down to double-A status can not be ruled out.

Hopefully, things will start to improve in due course, but should we experience another set-back on the road to recovery - perhaps a hung parliament, a sterling crisis or a series of failed gilt auctions, fixed income investors might do well to consider what other options are open.

The chart below shows the differing fortunes of the holders of ten-year German Bunds plotted against UK Gilts. The Gilt investor (green line) came into the equation a year ago with an input price just north of 108 for the UK Treasury 4.5% 2019. However, the year has not been kind to him with his holding now valued at 100.5, albeit with the benefit of a running yield on the holding of approximately 4%.

Our man in Frankfurt has had a better year, enjoying a fairly well-ordered uptrend that has seen the value of the Bund 3.5% July 2019 holding rise from 100 cents in the Euro to just under 104. The running yield on this holding has been slightly lower with ten-year bunds standing on a yield of around 3.1% at the start of the period.  

So, a total return of perhaps -3.5% for the Gilt holder and +7.1% for the Bunds, a superior result for our continental neighbour. However, potential investors in Bunds and other overseas debt should consider this one vital fact; namely, gains and losses in the currency will overshadow the relative performance of the assets. For instance, over the one-year period covered, the GBPEUR currency pair has traded a channel between €1.08 and €1.18 - a 9% range, greater than the moves seen on the bonds.

Take the timeline back further and the moves are more extreme. Five years ago, Sterling was valued some 27% higher against the Euro and investors who shifted funds into the single European currency will have benefited accordingly. Thus, it is fair to say that trading overseas bonds (particularly the higher quality, lower yielding examples) is largely a currency trade, as opposed to a pure income-generative investment.

In terms of the practicalities of trading European government bonds, things are looking up for the private investor. Bondscape, the wholesale dealing platform used by brokers to execute fixed income trades will shortly be offering the ability to buy and sell the benchmark Bunds. These bonds will be dealt and settled in Euros, although investors with Sterling-based accounts will be pleased to know that the platform will be able to offer GBP pricing and settlement for ease of administration.

Another potential route by which private investors might access the European government bond markets is via an ETF. iShares offer an excellent range of vehicles in this asset class covering both the short, medium and longer-dated end of the curve. These ETFs are backed by physical holdings, concentrated on the major and more creditworthy sovereigns. Looking at the 7-10 year € Government Bond iShares IBGM, the holding are mostly Germany, France and The Netherland (although Italian BTPs do sneak in). As with most ETFs, the Total Expense Ratio is quite reasonable at 0.2% per year and the bid-offer spread is tight, circa 0.14% according to my broker’s screen.

Mark Glowrey