The downside is you get par (in 2061)

The gilt market's widow-maker is a fantastic investment, if you are prepared to wait.

It’s rare that a bond achieves infamy, or indeed even gets much attention at all. So when I saw multiple articles on the UK Treasury 2061 (TG61), it was almost obligatory for a fixed-income blog to comment. It’s a trade that has gone wrong for many, but also a teachable moment for everyone¹.

My first encounter with the TG61s was in October 2022. I was seeing clients in Milan as the LDI crisis rapidly unfolded and, between meetings, I was glued to my phone, explaining to management in New York what an LDI was, and why they were selling £-IG, $-IG, and everything else they could get a bid on. Towards the end of the day, I caught up with a friend and colleague from Sales, who calmly asked me if 2061s were the trade of a lifetime. I pulled up Bloomberg to check TG61s first as a price, then as a yield, before giving my answer.

“Horrible trade, great investment.”

https://www.dividenddata.co.uk/uk-gilts-prices-yields.py

At the time my wife and I were saving for a house and it occurred to me that putting that deposit into the 2061s at 35c would provide a fantastic pension. Here was an opportunity to solve for retirement in one move - albeit at the cost of having to solve for the house later (or never). My colleague and friend was not interested: for him this was a “no brainer” trade for the short term. Gilts were, in his view, clearly oversold trading at distressed prices.

“What could go wrong?” He asked.

“They pay you par. In 2061.” I replied.

https://www.dividenddata.co.uk/uk-gilts-prices-yields.py

Yields up (prices down)

Even in the context of my career, 2022 was a busy year for credit markets, as series of interconnected crises played out. Inflation had picked up over the course of 2021, but it took until December for markets to stop believing that it was transitory in nature, and instead come to the realisation that inflation forecasts were less than worthless and that central banks would have to tighten policy rates…a lot. The first real hiking cycle in over a decade was then super-charged by the Russian invasion of Ukraine, which triggered a spike in European energy prices. This set in motion a relentless grind higher in interest rates that, combined with the ill-fated Truss government, resulted in a crisis for UK LDI managers².

One experience that was, I suspect, much more personal was the realisation that even extremely experienced bond investors were struggling to internalise the truism that bond prices fall as yields go up. On more than one occasion, I had found myself opposite an extremely excited High Yield/CLO manager asking why they shouldn’t buy some extremely low-price, long-dated GBP bonds such as BATSLN 2052s that were trading in the 50s.

Their argument was simple: these were large, blue chip companies, and therefore very, very unlikely to default - and if they did default the bonds would recover higher than their current prices anyway. So there was “no downside”. On the other hand, I knew that the low cash prices simply reflected that yields had risen and that these bonds had a very long duration. There was nothing surprising about them having low cash prices, it was just a mathematical artifact.

The gap between our perspectives largely came from HY being a cash-quoted market. High Yield managers simply were not used to seeing low cash bonds, unless the company was trading stressed/distressed. Through this lens, the potential to buy bonds from solidly investment grade companies at “distressed” (cash) prices looked like free money. Underlying this was a deeper, implicit assumption that the yield levels seen in late 2022 were a temporary blip. Transitory, if you will. After 10 years of zero yields, 5%+ returns were an aberration to be jumped on³.

So where was the downside? The downside was the risk that yields would stay at those Q4 2022 levels and that you got paid par at maturity, decades later. And that, more or less, is where we find ourselves in H2 2025. Still waiting for a “reversion” in interest rates that seems no closer than it was 3 years ago - even if policy rates have come down significantly from their peaks.

10y constant maturity benchmark yields. Source: FRED

A great investment (to maturity)

All that said, I do think that low-price gilts are a fantastic opportunity if you happen to be either foreign, rich enough that your UK pension/ISA allowances have already been filled (!), or a cash saver. That is because gilts are capital-gains tax free, a situation that may not be unique but is certainly unusual across the government bond markets that I reviewed several months ago.

As a result, low cash price gilts look fantastic versus many other asset classes, offering (credit) risk free, guaranteed yields equivalent to 5-7% versus other, taxable asset classes. Provided you are able to hold them to maturity⁴.

Equivalent yield on a taxable savings account assuming 0% CGT, 45% income tax

The rub is that most people in the UK have ample capacity in the two basic tax wrappers available: pensions and ISAs. Investments inside these wrappers are already free of capital gains tax and so the tax benefit of low-cash price gilts is lost, and they are just bonds offering 3-5% (still beating most savings accounts). To benefit from the capital-gains tax efficiency of gilts you need to have a substantial amount of cash sat outside of your ISA. And even then, to the whole point of this article, you need to match the duration of the bond to your investment horizon.

I own both the 2046 (5.23%) and IL46s (2.20% Real Yield)⁵. When they mature, I will be about 62 which means they line up nicely with my (hopeful) retirement. I also own some of the 2026 and 2028s because they beat most savings accounts, even on a pre-tax basis (and definitely post-tax). Through this lens, the TG61s are a poor investment for anyone born before 1995, as many of my peers and colleagues have found out.

1. Some ex-colleagues may have suffered through this lesson multiple times already.

2. LDI, Liability Driven Investing, refers to a investment strategy tailored for UK pension funds. Because pension accounting results in a deficit for funds when yields go down (and vice-versa), UK pensions are encouraged (required) to own assets whose prices go up when yields go down (but go down when yields go up). This is how bonds perform and hence UK pension funds tend to own a lot of bonds. As interest-rates rose over the summer of 2022 the bonds that LDI managers owned fell in price, triggering an unwind of leveraged positions that became self-reinforcing.

3. A similarly odd conversation involved a US hedge-fund manager who “discovered” they could buy $-HY bonds and hedge with CDS to make 3-4% of “free money”. This “free money” was, of course, just the underlying US Treasury yield, but it had been that long since yields were mid single-digits that even very smart people had forgotten this.

4. They do also offer a very cheap option on yields falling in the interim, but I think the value of that option is overestimated by many - or has been for most of the last three years.

5. Index-linked Gilts are inflation protected and currently offer a real yield (over and above inflation) of 2% which is fantastic for the bond part of a portfolio.