How to profit when the gilt bubble pops

An ugly monster of a bubble could be about to burst. And unlike the late 1990s dotcom bubble, this time it's in a dull, grey market associated more with crusty civil servants than flash entrepreneurs in pinstripes. I am talking about the market for UK government IOUs, or gilts. When this market blows up take cover. But set up the right spread bet first.

First, a quick bit of jargon gilt yields. In short, this is the annual expected return over the current price. Since most gilts pay a fixed income, the higher the price, the lower the yield. Earlier this month, yields hit a 300-year low. In a nutshell, that tells you that gilt prices are sky high. Why?

Three reasons. First, gilts are seen as safe in times of trouble. Pension fund investors in particular have piled in seeking a safe haven from global turmoil (after all, the UK government carries the highest AAA rating). Second, there are not enough of them around. Gilt auctions (where these IOUs are issued by the government) tend to be oversubscribed, and have been for years as pension funds scramble to find an asset that will pay for their obligations to retirees. Third money printing. In a bid to rescue a moribund economy the Bank of England has been merrily printing money via quantitative easing. Some of that money has been used to buy back government IOUs over the last few years, decreasing the supply and pushing up the price even more.

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So what could change? Well, the latest jobs data from the US suggests things have stabilised there -at least for now. Meanwhile, in Europe, the fact that Italian bond yields plummeted after the ECB intervened to prevent a full-blown Italian debt default, suggests there's hope the eurozone's sovereign debt woes can be managed, even if the underlying structural problems remain. Next investors have piled into gilts reckoning the UK is a decent bet while the rest of Europe grapples with its sovereign woes and the ongoing Greek crisis.

But as soon as there is even a glimmer of hope, why would these same investors stay in an asset that pays well below the rate of inflation? The merest hint that risk appetites are back (stock indices such as the FTSE 100 have climbed steadily for most of the month) could see money rush for the gilt safe haven exit and see gilt prices crash. If so, what can a spread better do?

Enter the long gilt future spread bet. This is in effect a bet on gilt prices, via the associated futures contract (for more on futures see my video: What are futures?). Here's how it works.

Let's say your broker is quoting a price of 11,692-11,695 for the March long gilt futures contract (this equates to prices for the underlying gilt of £116.92 and £116.95 per £100 nominal). You decide gilt prices are about to fall. So you sell at 11,692, placing a bet size of £10 per point (you can bet less, with a typical minimum being £2). You are proved right and the spread falls to 11,672-11,675. If you buy back the spread and close out, you make a profit of 11,692-11,675, or 17 points. That's £170 at £10 per point, all tax-free.

To cap losses should the bet backfire, you can ask for a guaranteed stop this should only widen the initial spread by aroundthree points.