Our kinky curve

Government bond yield curves are supposed to be nice and smooth, reflecting expectations of future monetary policy.

Sure, sections of the curve can get pushed around — as investors find themselves kettled into certain segments of the market by regulatory or liability-matching reasons — but weird kinks within these segments don’t tend to get too extreme unless there’s a liquidity crisis. The reason for this is simple: there’s money to be made by ironing out weird kinks.

Let’s check in on the gilt curve:

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Until around 2040 things look a bit messy. Beyond 2050 it’s a goat rodeo. What’s going on?

Pooja Kumra from TD Securities has an answer, publishing a note this week that examined micro relative value drivers across the gilt curve. If this sounds a bit geeky, it’s because it is. Should you care? Of course!

Kumra points out that the Bank of England’s active bond sales under its quantitative tightening programme is weighing on a few specific securities. A bit of repo specialness is present, but the overarching factor causing curve kinks is quite how wildly differing coupon rates have become across individual gilts.

A bond’s yield shouldn’t really depend on the size of its coupon. If you pay a high enough price on a high coupon bond you’ve bought yourself a low-yielding bond. And zero coupon bonds can become super high-yielders if their price gets low enough. Bond prices are very much the tail that gets wagged by the yield hound. 

But right now, low coupon gilts tend to have lower yields than high coupon gilts of a similar term to maturity or interest rate risk. This is for a few reasons.

First, institutional investors often prefer lower coupon bonds because they have more convexity than higher coupon bonds. (Translation from bond geek to bond tourist: as bond yields fall and prices rise, you get an increasingly bigger bang for your buck.) 

Second, while there’s no iron law saying the Debt Management Office can’t expand the supply of existing low coupon bonds, they tend to tap bonds that have close-to-current coupons, which is to say the higher coupons ones. And the prospect of uneven supply arguably keeps low coupon bonds rich to high coupon bonds.

But these aren’t the only things going on.

It was just over fifteen months ago that FTAV rang the bell on the weirdly compelling nature of low coupon gilts for UK taxpayers in a higher-yield environment. We wrote at the time that households’ de minimus participation in the market meant gilt pricing wasn’t really being affected. But things have changed. Retail flows have surged and there’s even a gilts thread on Mumsnet.

And so — *drum roll* — third, TD Securities reckon that the low-coupon retail tax factor now accounts for at least some of the messiness of today’s gilt curve.

Let’s recap the mechanics of the retail trade. 

A bond’s yield basically consists of:

1. the running yield; 

2. the difference between purchase price and par value.

UK taxpayers pay income tax on coupons that they receive as part of (1). But a long time ago the UK government decided that any capital gains or losses that arose from holding (coupon-bearing) gilts (ie 2) would be exempt from Capital Gains Tax. With prices of low coupon bonds much lower than par, the vast majority of their yield is therefore tax-free.

So tiny-coupon/low-price gilts currently offer taxpayers much higher after-tax yields than fat-coupon/high price gilts.

How much higher? We put our Excel skills to work estimating the after-tax yields that folks with different marginal tax rates might receive.

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Selecting a particular higher rate tax band in the filter at the top of that chart will show you how we reckon the yield curve might actually look to an individual retail punter. The messiness of the pre-tax curve turns into an almost random scatterplot for the Additional Rate taxpayer investing outside of any tax-free savings wrapper.

Can we quantify how much the curve is being distorted by the tax effect? In short, no.

But we can compare the yields of individual high coupon bonds to low coupon bonds that have around the same distance to maturity to get some sense of magnitude of the overall high coupon effect. Bond geeks will squeal that this is an oversimplification owing to differing durations, convexities, supply and repo dynamics — and they’d be right. But we’ll ignore them.

Comparing the yields offered to buyers of low-coupon 2061 gilts and higher-coupon 2060 gilts, we can see that until October 2021 their difference never exceeded two basis points. In September 2022 the whole market went briefly berserk for reasons. But in the subsequent higher-yield environment, where low-coupon bonds have particular value to retail holders, the spread never recovered. It now sits at around 28 basis points.

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Successful gilt investors have typically focussed on getting the big calls right: duration and curve shape, driven by their expectations for future monetary and fiscal policy. And that’s absolutely not going to change anytime soon.

But as TD Securities puts it:

…the Gilt curve has now sub-curves within its structure. In a lower rate environment it was driven by scarcity impact, and in a high rate environment it is being driven by the coupon impact. … [lower coupon bonds] continues to gain traction from domestics on back of tax benefits (eg Oct 61s).

The scale of the retail bid is hard to quantify. It’s probably still quite small, if fast-growing. But it’s grown big enough to make its way into the calculations of fixed income arbitrageurs, and to put at least a couple of kinks into the UK yield curve.