Does it make sense to buy into Gilts now, although interest rates will rise?
The difference between 2- and 10-year on-the-run Gilts
The on-the-run 10-year Gilt (GB00BMV7TC88) offers a yield of 4.65% and pays a semiannual coupon of 3.25%.
If you buy it today and decide to sell it in a year, you will lose -1% if the yields rise to 5.25%. Otherwise, you will gain 9% if yields drop to 4%. If you decide not to sell it, you will receive a coupon of 3.25% every year.
When interest rates rise, the risk-reward tradeoff is more appealing in short-term government bonds. The on-the-run 2-year Gilt (GB00BK5CVX03) offers a yield of 5.4% and pays a coupon of 0.625%. If you buy it today and decide to sell it in a year, you will lose -0.1% if yields rise to 6%, and you will gain 2.13% if yields drop to 4.8%. Suppose you hold the bond until you receive 0.625% every year.
From the example above, the bigger coupon on the 10-year Gilt decreases the bond's convexity, making it less sensitive to interest rate rises. However, the short duration of the 2-year note creates a nice buffer to losses despite the lower coupon.
Are deeply discounted 40-year Gilts a good idea?
The way taxation works in the UK makes it more convenient for bond investors to hold bonds with the minimum coupon and the biggest capital gain to benefit from capital gain exemptions and avoid income taxes. That naturally leads UK residents to pick bonds with the maximum convexity. However, are they a good idea?
The Gilt with 2061 maturity (GB00BMBL1D50) pays a coupon of 0.5% and trades at 30 cents on the dollar. If kept until maturity, it will provide an annualized return of 4.2%. Yet, if you need to sell it in one year and the yield moved by 50bps, you will face a loss or gain of roughly 15%.
While it may be true that rates might decline at a certain point in the future, we cannot be certain at which level they might stabilize. The big problem with holding such an instrument is the loss of opportunity. By now, if you were invested in such an instrument, you would have lost the opportunity to buy much less risky and higher-yielding securities. The problem multiplies as rates continue to soar.