Analysis: Are British bonds a riskier bet than they look?

Wed May 23, 2012 6:15am EDT
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By David Milliken

LONDON (Reuters) - Investors fleeing the euro zone 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 U.S. and German government debt as investors have scurried away from riskier stocks and the questionable debt of crisis-hit, mainly southern, euro zone 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 euro zone economy itself.

"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 10-year gilts, the yield sank to 1.809 percent on Friday from over 4 percent in more normal times a couple of years ago. It was lowest yield since similar gilts were first issued after World War Two.

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