UK gilt ETFs enjoy post-Brexit surge as yields collapse

Jun 28th, 2016 | By | Category: Fixed Income

In the aftermath of the British people’s decision to secede from the European Union, the UK has lost its AAA rating from Standard & Poor’s , while Moody’s has downgraded its credit outlook from stable to negative.  The change is reflective of the heightened uncertainty surrounding the UK’s political and economic future. Despite the downgrade, yields on UK gilts were forced lower following the vote as investors flocked into safe-haven assets, bringing gains to investors in UK gilt-tracking exchange-traded funds.

UK gilt ETFs enjoy post-Brexit surge as yields collapse

UK gilt ETFs enjoy post-Brexit surge as yields collapse

While the pound and the euro tanked against other currencies, and UK and European equities plummeted – RBS and Barclays shares even suspended trading – UK government bond ETFs surged.

The 10-year UK gilt yield fell from 1.37% on 23 June to 0.93% on 27 June. The yields on shorter term debt, which often experience the greatest increase in investor demand during periods of uncertainty, effectively collapsed within three days. Five-year debt yields halved over the same time, to 0.40%. Even more dramatic, yields on the two-year fell by more than two-thirds to 0.15% since the referendum result.

The collapse in yield and rise in price has benefited government fixed income ETFs.

The iShares Core UK Gilt UCITS ETF (IGLT), which tracks a mix of shorter and longer dated government debt, has risen more than 4.4% since 23 June. The iShares UK Gilts 0-5 year UCITS ETF (IGLS), which tracks bonds that expire between zero and five years, rose 1.1% since the Brexit news.

The UK’s downgrade comes amid forecasts of an “abrupt slowdown in growth” and “a deterioration of the UK’s economic performance, including its large financial services sector”. The move from S&P is the first time it has downgraded the UK since 1975.

A rating downgrade can push up the yields on government bonds, signalling they are a less safe investment. In this case – post Brexit – sovereign yields in the UK have come down. And as for the near term, the country’s lower credit rating does not necessarily mean that borrowing costs for the government will go up.

This is for two main reasons, according to BBC economics correspondent Andrew Walker.

First, investors are offloading riskier assets and buying safer ones like government bonds, and that demand pushes down yields and bolsters prices.

Second, the Bank of England may reduce interest rates in the volatile aftermath of Brexit in order to protect the economy, instead of hiking the base rate, unchanged since 2009, as has been long forecast.

Overall the risk attached to UK gilts might be higher than last week, but they still remain a safe harbour compared to equities or corporate bonds.

There are 12 ETFs available in Europe that track gilts, from iShares, db X-trackers, Lyxor and SPDR. The cheapest is the Lyxor UCITS ETF iBoxx £ Gilts (DR) GBP (GILS) at just 0.07%.

UK Chancellor of the Exchequer George Osborne sought to reassure markets by saying the UK will face its future “from a position of strength” and although it would need time to “adjust”, it would be strong enough to cope.

But further uncertainty for capital markets and bonds lies ahead as countries like France, Italy and Germany have refused to hold informal talks with UK leaders until it has triggered so-called Article 50, signalling its intention to leave the European Union. Reverberations are likely to continue across financial markets as Prime Minister David Cameron has ruled out the possibility of a second referendum.

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