The Bank of England will hike until something breaks, and even then, it might not be able to pivot

As the Financial Times rightly pointed out, long-term real yields recently turned positive. Positive and elevated real yields are mirroring tighter financial conditions. However, are they high enough to affect the economy right now? Probably not.

Real rates are nominal rates minus the breakeven rate. The breakeven rate tells us where inflation will be some years into the future. Let's take the 5-year UK breakeven rate as an example, now trading at 3.99%. Although consumers might disregard where inflation expectations are in five-year times, they know where inflation was in May: 8.7%. Therefore, as they take on a 5-year loan today, they are paying a negative real rate on their loan. Although this point is arguable, it's fair to say that consumers are generally interested in the convenience of taking on debt today, not in a few years, based on market expectations.

That means if the BOE wants to be restrictive, it needs much higher real rates across the whole yield curve, which implies aggressive monetary policies for longer.

What does that mean for bonds?

Gilt yields have room to move higher and the yield curve to continue to invert as bond futures price more interest rate hikes.

The UK 2-year swap remains elevated, suggesting that 2-year Gilt yields remain compressed despite soaring by 20bps this week. The potential is for them to rise to 6% ahead of the August 3^rd BOE meeting, especially as the FED prepares to deliver another rate hike.

Ten-year Gilt yields have also the potential to rise to 5.25%, the 2008 peak level.

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.