Gilts to Beat U.S., German Debt After Worst Quarter in 14 Years

By Agnes Lovasz

July 10 (Bloomberg) -- U.K. government bonds are poised to rebound from their worst quarter in more than 14 years, beating U.S. and European debt, as the slowest economic growth since 1992 keeps the Bank of England from raising interest rates.

The slumping economy will drive 10-year gilt yields down to 4.74 percent by year-end, from about 4.87 percent yesterday, according to the median estimate of 13 strategists surveyed by Bloomberg. Pacific Investment Management Co., manager of the world's largest bond fund, says U.K. debt looks ``attractive.'' Invesco Asset Management is going ``overweight'' gilts, meaning it plans to hold a greater percentage of the debt than the benchmark indexes it uses to measure performance.

``The U.K. economy will do pretty badly and this will support the bond market,'' said Axel Blase, a Frankfurt-based fund manager at Invesco, which holds about $160 billion in fixed- income assets.

The worst property slump in 30 years, the highest mortgage rates since 2000 and rising fuel and food costs in Europe's second-biggest economy are stoking demand for the safest assets. The economy will expand 1.7 percent in 2008, according to the median estimate of 31 strategists surveyed by Bloomberg, down from 3 percent last year. The risk of a recession is ``serious,'' the British Chambers of Commerce said July 8.

The slump is likely to keep the Bank of England from raising its key interest rate from 5 percent at a meeting today even after inflation accelerated in May to 3.3 percent, the fastest pace in more than a decade. All but one of 49 economists surveyed by Bloomberg predict the bank will leave rates unchanged.

`Extremely Weak'

The housing market will be ``extremely weak'' and policy makers won't ``overreact'' to inflation, central bank Governor Mervyn King said in testimony to Parliament on June 26. The European Central Bank lifted its main rate to 4.25 percent on July 3, its first increase in a year.

``The U.K. looks attractive against Europe,'' said Myles Bradshaw, a fund manager at Pimco in London. ``In terms of rate expectations they are pretty similar but the difference is that the U.K. has got a much weaker growth outlook than Europe. Our sense is that the BOE won't need to raise rates as the weakness in growth will pull inflation down.''

The yield on the 10-year gilt fell 2 basis points to 4.87 percent yesterday. The 4.75 percent security due March 2018 rose 0.17, or 1.7 pounds per 1,000-pound ($1,981) face amount, to 100.98. The two-year yield was little changed at 4.88 percent.

Inflation Threat

The 17 basis-point decline in the 10-year yield forecast in the Bloomberg survey would give an investor buying $10 million of the securities today a profit of about $336,000 by Dec. 31. Ten- year bund yields will drop 11 basis points, producing a gain of $287,000 on the same amount invested, while 10-year Treasury yields will rise 13 basis points for a profit of $68,000, based on Bloomberg surveys.

Yields have further to rise because inflation will accelerate as fuel and food prices increase, according to Philipp Brugger, a fixed-income manager in Frankfurt at DWS Investment GmbH. The firm oversees about $52 billion.

``I don't want to enter the market now because in the short term high inflation numbers will limit a rally in gilts,'' he said. ``They'll get cheaper and cheaper.''

Expectations for inflation over the next decade have risen to the highest level since April 1997, according to the difference in yield, or spread, between the 10-year gilt and its index-linked counterpart. The so-called breakeven rate was at 3.97 percent today, from 3.69 percent on May 26.

Second-Quarter Losses

Bonds around the world fell in the second quarter as crude oil rose to records, stoking speculation that central banks would have to raise borrowing costs to quell inflation. Oil climbed 35 percent in the three months through June, the biggest quarterly gain in nine years, and traded at an all-time high of $145.85 a barrel on July 3.

Investors holding U.K. government debt lost 3.9 percent in the three months through June 30, the worst return since the second quarter of 1994, according to Merrill Lynch & Co.'s U.K. Gilts Index. U.S. bonds lost 2.1 percent, according to Merrill's Treasury Master Index, and euro-region debt tumbled 3 percent, Merrill Lynch's EMU Direct Government Index showed.

The prospect of rising rates pushed the yield on U.K. two- year notes to 5.57 percent on June 16, the highest level since August, just as the global credit markets started to seize up and investors sought the safety of government debt.

Traders pared bets on rate increases, with the implied yield on the September short-sterling futures contact falling 28 basis points to 5.94 percent since June 16. Policy makers will reduce rates by 25 basis points to 4.75 percent by year-end, according to the median estimate of 16 economists surveyed by Bloomberg.

``The Bank of England would like to avoid any rate hike due to the dismal growth outlook,'' said Martin Hochstein, a fund manager in Frankfurt at Cominvest Asset Management, which oversees about $27 billion of bonds. He also said gilts are ``looking attractive.''

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net