Are gilts riskier than they look?

London: Investors fleeing the Eurozone to seek safety in British government bonds may be taking a riskier bet than they think: The ultra-low interest rates the shrinking UK economy is paying look unlikely to last.

British government bonds, nicknamed gilts after the gold leaf that used to adorn the paper certificates, have surged in price alongside US and German government debt as investors have scurried away from riskier stocks and the questionable debt of crisis-hit, mainly southern, Eurozone countries.

They have been helped along also by huge stimulus buying from the Bank of England, which it suggested in minutes released on Wednesday it is willing to start up again if the economy worsens.

But gilts may not be as safe a haven as some investors are counting on, with Britain suffering from hefty public borrowing, relatively high inflation and significant exposure to any worsening the Eurozone economy itself.

Dragged down

"The UK has essentially used up all of its wiggle room," said Sam Hill, a fixed income strategist at RBC who previously worked for fund managers Threadneedle Investments. "The UK might be in some ways separate, but would equally still be dragged down ... if there was a more severe outcome in Europe."

Investors' desire to avoid risky assets — along with pump-priming buying by the Bank of England — has sharply reduced the annual interest rate, or yield, that Britain's government has to pay on new debt.

For benchmark ten-year gilts, the yield sank to 1.809 per cent on May 18 from over 4 per cent in more normal times a couple of years ago. It was lowest yield since similar gilts were first issued after the Second World War.

Over the same two-year period, a markedly different view of Spanish debt has taken yields from 4 per cent to over 6 per cent. Demand for German debt, meanwhile, has been even greater than for British — two-year government bonds sold on Wednesday will pay nothing.

The falling return on gilts, however, does not reflect any reduction in their outright risk. The cost of insuring gilts against default has risen almost 30 per cent over the past year, compared with an unchanged cost for US debt.

Public debt problem

Despite this, ten-year gilts offer a yield that is only 0.1 percentage points higher than US Treasuries and 0.4 percentage points over German Bunds.

"I wouldn't say gilts are a particularly good investment relative to Treasuries," said Ian Fishwick, a fixed-income fund manager at Fidelity Worldwide Investment, which holds about £2.5 billion (Dh14.4 billion) of gilts.

"The UK does have a problem with the scale of public debt and ... the dollar's reserve currency status is a lot more secure than sterling's," he added.

Britain's annual government borrowing amounts to more than 8 per cent of gross domestic product. This is roughly triple Germany's rate of borrowing, and only slightly below that in the United States — which has the advantage of stronger long-term growth with which to service the debt.

Moreover, Britain's economy and banking system is much more vulnerable to a Eurozone downturn than the US, with around half of Britain's trade going to the rest of Europe.