Why Are You Buying Gilts?

This is an article recently published in ROOM 151 under the title 'Why Are LGPS Funds Considering Gilts?

The clearest trend in the recent Room 151 LGPS survey is the increasing interest in gilts.  The principal reason must be the returns on offer today.  Conventional gilts can match future cashflows and at the time of writing they also deliver a small excess return over the average fund discount rate of 5.5%.*  Index linked gilts offer about 3% lower return but with absolute protection (absente Government default) against future inflation rises.

There is competition for investors’ money

Despite the media comment there is little evidence that the rise in gilt yields is caused by concerns over inflation or fiscal incontinence, even in America.  The cause is much more likely to be competition for capital from AI investment.  Over the next five years, something like US$10 trillion is scheduled to be invested in AI infrastructure.  Until now, most has been financed by internal cashflow, but going forward loans will account for at least 50% of the financing. 

The numbers are colossal, about 3.6% of GDP, or 50% greater than in the Victorian railway boom.  History tells us that the outcome of this scale of investment in new technology may be good for the world, but it is rarely good for investors.  The reason is the capital expenditure cycle: over-investment leads to over-capacity and destroys returns.  In practical terms, the winners will be able to pay their lenders back, but the inevitably more numerous losers will not.  In summary, even today’s venal governments are a better credit risk than lending for AI capex.

Reasons for buying gilts

Returning to the headline of this article, I am not suggesting that LGPS funds are wrong to be considering raising gilt allocations.  But it is important to analyse and understand why you hold gilts in your portfolio.  Here, there are a number of cross-currents swirling around.

Some investors hold gilts today because their risk-adjusted returns look attractive at a time when some of the competing asset classes (private credit, equities, even infrastructure) are under pressure.  This may be for tactical or (my preference) strategic reasons.

A second reason may be the desire to de-risk portfolios on the basis that gilts match future liabilities in a securer way than equities.  Traditionally, gilts were seen as safer than equities i.e. fit for widows and orphans.  However, in the past few years gilts have been more volatile, and their diversification benefits have been questioned.,

They should behave more normally in the future.  This is because the recent period has been anything but normal in two ways.  Yields were at extreme lows until 2021, increasing duration and therefore dialling up sensitivity to any interest rate move.  Secondly, the normalisation of yields since 2022 to today’s levels has been the dominant force in gilts’ price action.

In the future, with yields back to normal levels, neither of these factors will be present to the same extent, if at all, and I expect gilt prices to behave as they did prior to the Global Financial crisis.  They will not be as volatile, and they will deliver some diversification benefit over the economic cycle.

Gilts can also provide some liquidity for pension funds at a time when illiquid holdings have risen to 25% or even 30% for many LGPS funds.  Without them, funds have little choice but to sell listed equities to cover any cash shortfall, whether to pay pensions, to fund a private asset drawdown, or to finance the exit of an employer.   

In summary, it is important to have a clear mind why you are buying gilts, even if MHCLG’s asset allocation template only has one bucket for them.  The three main justifications are as part of the long-term funding strategy, for asset investment considerations, or as a liquidity buffer either against cashflow emergencies or to take advantage of investment opportunities.

Behavioural bias

Another consideration is how to mitigate behavioural bias.  At fund level, LGPS Committees tend to have a bias to higher growth equities in the hope that they will eventually lead to lower contributions.  On top of that there is pressure from the Government to invest in growth.   

At pool level, there is the difficulty of providing a standardised product for different funds holding gilts for different reasons.  There may also be a lack of experience of investing in gilts among senior managers, simply because they haven’t been part of the LGPS allocations for 15 years.  The complexities of index-linked gilts in particular may be less familiar.

Should LGPS funds hold any gilts?

When I posted on this subject on LinkedIn a few weeks ago, one strand of the comments questioned why LGPS funds should hold gilts at all.  They might as well hand the assets and liabilities back to the Government.  Alternatively, they should show a greater appetite for risk and invest in private credit and growth.

If LGPS funds had 100% in gilts, I could sympathise with those arguments.  However, the aggregate weighting in gilts today is about 6%* and they are there to perform specific functions within a diversified portfolio.  

I am therefore supportive of the trend to increase allocations.  I argue that it is essential to be explicit which function your gilts are fulfilling.  As a footnote, I wish MHCLG had separated out index-linked and conventional gilts in their strategic asset allocation template.  I fear that that is now water under the bridge.

*2025 Scheme Annual Report