U.K. Bonds Thrive as `Brexit' Jitters Prompt Flight to Safety

  • Sovereign debt outperforms developed-nation peers in 1st qtr
  • Traders are pricing in possibility of Bank of England rate cut

U.K. sovereign bonds are the best performers among developed nations this year as the looming referendum on European Union membership prompts demand for safe assets.

The securities outperformed their U.S. and German peers by at least a percentage point in the first quarter as “Brexit” jitters intensify in the run-up to the June 23 vote. By contrast, the pound is set for its worst quarter since 2009 and options traders are betting on more declines. Further boosting gilts are fading bets that the Bank of England will raise borrowing costs anytime soon.

“The outcome of the EU referendum is very difficult to call, but what seems obvious is that tensions will continue to mount, which supports more of that flight to quality,” said Peter Chatwell, head of rates strategy at Mizuho International Plc in London.

Gilts returned 4.8 percent this quarter through Wednesday, compared with gains of 2.9 percent for U.S. Treasuries and 3.8 percent for German bonds, according to Bloomberg World Bond Indexes.

The 10-year gilt yield fell three basis points, or 0.03 percentage point, to 1.40 percent as of 11:41 a.m. in London on Thursday, down from 1.96 percent at the end of 2015. It touched a record-low 1.226 percent on Feb. 11.

Earlier this year, analysts predicted that it would be tough for gilts to sustain their run unless investor concerns around the vote came back in focus.

BOE Warning

Recent polls show the outcome of the referendum is too close to call, raising the possibility that Britain might leave the EU after 43 years of membership in the bloc. The Bank of England on Tuesday put the risk of a Brexit at the top of its list of near-term domestic threats. Forward contracts based on the sterling overnight index average, or Sonia, are pricing in the possibility of an interest-rate reduction this year.

“Until we get through it and have some clear evidence that growth remains on track on the other side of the referendum,” the prospect of a rate increase remains dim, said John Wraith, a gilts strategist at UBS Group AG in London.

Wraith expects Britain to remain in the EU and sees the 10-year yield climbing to 1.8 percent by the end of the year. But gilts will stay in a “holding pattern” until the referendum, he said.

How foreign investors perceive the risk of the “leave” vote prevailing is crucial because they hold about a quarter of the total stock of gilts.

Net gilt sales by foreign investors was 3.016 billion pounds ($4.4 billion) in February, according to Bank of England data released Thursday. This was the biggest back-to-back net sales since April 2014, as the January reading was 6.3 billion pounds.

Rates Cut?

On balance, a Brexit would probably boost the securities, though there is much uncertainty, said Seamus Mac Gorain, London-based global fixed-income portfolio manager at JPMorgan Asset Management, which oversees about $1.7 trillion globally.

“Some say it will cause a loss of confidence in the U.K. among foreign investors and increase risk premia on gilts and therefore push up yields, while some think the BOE will ease and this will be bullish for gilts and push down yields,” he said.

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