Shares: Worries provide an ideal time to indulge in gilts

THE VIOLENCE of the mood swings affecting capital markets can be a source of profits for patient investors. This year, there has been a staggering about-turn in sentiment in bonds, with the UK gilts market among the worst-affected. There is a good case for saying that prices are close to a short- term low at least, and that significant profits could be made from buying at current levels.

While underlying inflation may be settling down between 2 and 4 per cent, it is even possible that longer-dated gilts, on yields close to 8 per cent, are offering a last chance to buy before another dramatic fall in yields.

There are three principal reasons why bond markets have plunged so heavily in 1994. First, they had a huge rise in 1993 as part of a 1990s bull run that may have been the greatest ever in fixed-interest markets. Nobody sells faster than a speculator with fast-disappearing profits to protect. The mayhem was compounded by forced selling by hedge funds that were financing bond holdings with short-term borrowings.

Second has been a change in emphasis in US monetary policy, switching from merely reacting to inflationary pressures to mounting a pre-emptive strike when a strong recovery in the real economy merely raised the possibility of future inflation.

Third has been the collective recollection of investors that for decades, every significant economic recovery has ended in an unpleasant bout of stagflation, with a period of sharply rising interest rates and collapsing bond prices.

Put all that together and it is hardly surprising that fear overcame greed and left short- term holders baling out of the market in conditions of near- panic, while big institutional investors stayed on the sidelines piling up cash.

The result is that despite an almost complete absence of signs of inflationary pressure in the world's developed economies, long-dated bond yields have risen dramatically.

In the US, yields have risen from under 6 per cent to close to 7.5 per cent; in Britain they climbed from under 6.5 per cent to almost 8 per cent at one stage.

The bullish argument is that this has created the potential for a big rally. The market offers excellent value and the institutions have plenty of cash to invest. It only needs something to trigger the return of the buyers and prices could take off, with a scramble to buy almost as frenzied as the recent bouts of near-panic selling.

Private investors willing to take a view should buy ahead of this development. Aggressive investors could even look at the derivatives markets (options and futures) with a view to maximising their gains - or losing all their investment if the bull case proves wrong.

I have applied the same overbought-oversold analysis to UK gilts that I used last week to look at the equity market. Based on plotting movements in the redemption yield on Treasury 11.75 per cent 2007 against its nine-month moving average, I identified six occasions between 1979 and 1990 when a gap of around a percentage point opened up between the current yield and the moving average, signifying an oversold position.

On two occasions, the position became slightly worse before it became better but thereafter, in every case, gilt yields then fell significantly to provide good profits for buyers.

We now have the seventh occasion since 1979 when gilts have become oversold, signalling a buying opportunity. That is not a guarantee that buying is worthwhile but is certainly an encouraging pointer.

Against the risk of further bad news from the US if its economy continues to grow strongly or there are further rises in short-term US interest rates, there is the argument that a still-depressed Europe should be able to decouple its bond markets from the US trend.

Recent weeks have provided some evidence that the decoupling theory is starting to work. Admittedly, Britain is stuck in the middle, with its economy stronger than Europe's but hardly blazing away like that of the US. But this is allowed for in the massive 145 basis points (nearly 1.5 percentage points) of additional yield on UK longer-dated gilts relative to German bonds.

Unlike the situation with equities, it is much less important with gilts which one is actually bought. The most important variable is the redemption date. The greater risks and potential rewards come from buying longer-dated stocks.

Treasury 8 per cent 2009, for example, is currently priced at pounds 1021 8 to offer an annual running yield of 7.83 per cent. If held to redemption there would be a slight capital loss, reducing the gross redemption yield to 7.74 per cent. So far this year, the price has varied between nearly pounds 116 and just under pounds 100, showing how volatile gilts are today.

Nobody should believe that buying gilts is anything but a highly speculative alternative to leaving money in the building society, with potential to generate large profits and significant losses. But I believe buyers should do well now even on quite a short-term view.

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