Gilts Trail in Worst Global Bond Month Since 2004: U.K. Credit

In the worst month for fixed-income assets in almost a decade, U.K. government bonds suffered more than most.

As sovereign securities across the world declined in May amid speculation the Federal Reserve may taper its bond-buying plan, British debt trailed all but one of the 26 markets tracked by Bloomberg. Bank of England Governor Mervyn King said May 15 that a U.K. recovery is “in sight” while investors are betting his successor, Mark Carney, may pursue new strategies to boost economic growth.

“The market view that seems to be emerging is that more support from a Mark Carney BOE would not necessarily be in the form of more vanilla gilt purchases,” said Moyeen Islam, a fixed-income strategist at Barclays Plc in London. “The data has been OK, and the May Inflation Report essentially took more quantitative easing off the table, so there is little reason to suppose that more action is imminent.”

Rising borrowing costs may make it harder for Prime Minister David Cameron to argue his budget cuts retain credibility with investors. U.K. gilts declined 2.4 percent in May, the most since December 2009, and the second-worst performer after South African bonds in indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.

Yields Climb

The 10-year gilt yield was little changed at 2 percent at 3:45 p.m. in London after climbing 31 basis points, or 0.31 percentage point, in May. The rate compares with an average of 1.80 percent during the past 12 months, and a record-low 1.407 percent in July.

Securities in the Bank of America Merrill Lynch Global Broad Market Index fell 1.5 percent last month, the steepest loss since April 2004.

While 10-year gilts outperformed their U.S. equivalents last month, the yields on shorter-dated U.K securities increased more. Their appeal was dented as Bank of England policy maker Paul Fisher said May 24 that he’s not convinced about the merit of cutting the central bank’s key interest rate, which has been at a record low of 0.5 percent since March 2009.

Bank of England minutes from February showed officials considered options including a rate cut as ways to help the economy. Governor King has voted to boost the central bank’s bond-purchase program from 375 billion pounds ($573 billion) at each meeting since then, though he has been outvoted by other members of the Monetary Policy Committee.

Perverse Effects

“Further cuts in rates may not feed through to higher consumption in the normal way and some of the effects could even be perverse,” Fisher said. “We may well find that getting rates back to normal is part of re-establishing economic activity at potential in due course.”

The two-year gilt yield rose 13 basis points in May to 0.37 percent. That pushed the yield difference, or spread, over their U.S. equivalents up by four basis points to eight basis points.

Two-year gilts have underperformed their U.S equivalents as “data has improved and the MPC has downplayed any chances of a rate cut,” said Jason Simpson, a rates strategist at Banco Santander SA in London. “Overnight index swaps were at one stage most of the way to pricing a 25-basis points cut. This discounting of lower rates has gradually unwound and pushed two-year gilt yields up with it.”

Sonia Contracts

Traders use derivatives based on the sterling overnight index average, or Sonia, to protect against future changes in interest rates.

The contracts show traders are not expecting a rate cut before April 2014, data from Tullett Prebon Plc shows. The Sonia contract for next March, which was at 0.255 percent on April 22, has risen to 0.402 percent.

Britain’s economy resumed growth in the first quarter, expanding 0.3 percent, the Office for National Statistics said May 23 in London, matching an estimate published on April 25. U.K. house prices increased the most in 18 months on an annual basis last month, Nationwide Building Society said May 30.

“There is a welcome change in the economic outlook,” King said at a quarterly press conference in London on May 15, his last before retiring as central-bank governor. “We don’t see a particularly rapid recovery in the next few quarters but we do see a recovery and I think there are good reasons for that.”

‘Escape Velocity’

Carney, who is scheduled to succeed King as governor in July, said earlier this year that central banks aren’t “maxed out,” and that their task is to achieve “escape velocity” for their economies. The International Monetary Fund said last month that the Bank of England may need to buy more gilts and assure households and investors that rates will stay low until the recovery reaches “full momentum.”

The Debt Management Office plans to hold 11 outright sales of gilts and two offerings via banks between July and September, it said on its website May 31.

“There is a relatively heavy supply schedule and there are currently no supportive Bank of England buyback operations taking place,” said Simon Peck, a rates strategist at Royal Bank of Scotland Group Plc in London. “The net risk the market has to take down is rising. That’s one of the drivers behind the general underperformance we’ve seen in gilts and I expect to see that continue into coming quarters.”

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